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Beacon Power 10-K 2008

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Table of Contents
Item 8. Financial Statements and Supplementary Data



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549


FORM 10-K

(Mark One)  

ý

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2007

Or

o

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from                to                

Commission file number 000-31973

Beacon Power Corporation
(Exact name of registrant as specified in its charter)

Delaware
(State or other jurisdiction of
incorporation or organization)
  04-3372365
(I.R.S. Employer
Identification No.)

65 Middlesex Road
Tyngsboro, MA

(address of principal executive offices)

 

01879
(Zip code)

(978) 694-9121
(Registrant's telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Act:

Title of each class:
  Name of each exchange on which registered:
Common Stock, par value $.01 per share   The NASDAQ Stock Market LLC
(NASDAQ Capital Market)
Preferred Share Purchase Rights   The NASDAQ Stock Market LLC
(NASDAQ Capital Market)

          Securities registered pursuant to Section 12(g) of the Act: None

          Indicate by check mark if the registrant is a well known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes o    No ý

          Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes o    No ý

          Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ý    No o

          Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K ý

          Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer or a "smaller reporting company" per rule 12b-2 of the Exchange Act.

Large accelerated filer o   Accelerated filer ý   Non-accelerated filer o
(Do not check if a smaller reporting company)
  Smaller reporting company o

          Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes o    No ý

          As of June 30, 2007 the market value of the voting and non-voting common stock of the registrant held by non-affiliates of the registrant was $88,070,031. In determining the market value of non-affiliated voting stock, shares of the registrant's common stock beneficially owned by each executive officer, director and any known person to be the beneficial owner of more than 20% of the registrant's voting stock have been excluded. This determination of affiliate status is not necessarily a conclusive determination for other purposes.

          The number of shares of the Registrant's common stock, par value $.01 per share, outstanding as of March 7, 2008 was 88,668,488.

DOCUMENTS INCORPORATED BY REFERENCE

          The Exhibit Index (Item No. 15) located on pages 120 through 122 incorporates several documents by reference as indicated therein.





Table of Contents

 
   
  Page

PART I

 

 

 

 
  Item 1.   Business   1
  Item 1A.   Risk Factors Relating to Our Business   14
  Item 1B.   Unresolved Staff Comments   21
  Item 2.   Properties   21
  Item 3.   Legal Proceedings   22
  Item 4.   Submission of Matters to a Vote of Security Holders   22

PART II

 

 

 

 
  Item 5.   Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities   22
  Item 6.   Selected Consolidated Financial Data   23
  Item 7.   Management's Discussion and Analysis of Financial Condition and Results of Operations   24
  Item 7A.   Quantitative and Qualitative Disclosures about Market Risk   42
  Item 8.   Financial Statements and Supplementary Data   43
  Item 9.   Changes in and Disagreements with Accountants on Accounting and Financial Disclosure   78
  Item 9A.   Controls and Procedures   78
  Item 9B   Other Information   78

PART III

 

 

 

 
  Item 10.   Directors, Executive Officers and Corporate Governance   78
  Item 11.   Director and Executive Officer Compensation   83
  Item 12.   Security Ownership of Certain Beneficial Owners and Management   114
  Item 13.   Certain Relationships and Related Transactions, and Director Independence   116
  Item 14.   Principal Accountant Fees and Services   118

PART IV

 

 

 

 
  Item 15.   Exhibits, Financial Statement Schedules   120
  Signatures   123

i


Note Regarding Forward Looking Statements:

        This Annual Report on Form 10-K may include statements that are not historical facts and are considered "forward-looking" statements within the meaning of the Private Securities Litigation Reform Act of 1995. These forward-looking statements reflect Beacon Power Corporation's current views about future events and financial performances. These "forward-looking" statements are identified by the use of terms and phrases such as "believe," "expect," "plan," "anticipate," and similar expressions identifying forward-looking statements. Investors should not rely on forward-looking statements because they are subject to a variety of risks, uncertainties, and other factors that could cause actual results to differ materially from Beacon Power Corporation's expectation. These factors include: a short operating history; a history of losses and anticipated continued losses from operations; a need to raise additional capital combined with a questionable ability to do so; the complexity and other challenges of arranging project financing and resources for one or more frequency regulation power plants, including uncertainty about whether we will be successful in obtaining DOE loan guarantee support for our New York facility; conditions in target markets, including the fact that some ISOs have been slow to comply with the FERC's requirement to update market rules to include new technology such as ours; our ability to obtain site interconnection or other zoning and construction approvals in a timely manner; no experience manufacturing any product or supplying frequency regulation services on a commercial basis; limited commercial contracts for sales to date; the dependence of sales on the achievement of product optimization, manufacturing and commercialization milestones; the uncertainty of the political and economic climate, and the different electrical grid characteristics and requirements of any foreign countries into which we hope to sell or operate, including the uncertainty of enforcing contracts, the different market structures, and the potential substantial fluctuation in currency exchange rates in those countries; dependence on third-party suppliers; intense competition from companies with greater financial resources, especially from companies that are already in the frequency regulation market; possible government regulation that would impede the ability to market products or services or affect market size; possible product liability claims and the negative publicity which could result; any failure to protect intellectual property, including the effect of the patent litigation recently initiated against us; retaining key executives and the possible need in the future to hire and retain key executives; the historical volatility of our stock price, as well as the volatility of the stock price of other companies in the energy sector. Such statements made by us fall within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. All such forward-looking statements are necessarily only estimates of future results and the actual results we achieve may differ materially from these estimates due to a number of factors as discussed in the section entitled "Item 7. Management's Discussion and Analysis of Financial Condition" and "Results of Operations" of this Form 10-K. Beacon Power Corporation expressly does not undertake any duty to update forward-looking statements.



PART I

Item 1.    Business

Overview

        Beacon Power Corporation and our subsidiary, Beacon Power Securities Corporation, (collectively "Beacon," "the Company," "we," "our" or "us") design, develop, configure and expect to begin offering for sale, services and advanced products to support more reliable and cost-effective electricity grid operation. We believe that our sustainable energy storage and power conversion solutions can help provide reliable electric power for the utility, renewable energy, and distributed generation markets. We are a development-stage company that was incorporated in Delaware on May 8, 1997. Because we have not yet generated commercial revenue from our expected principal operations which will be to provide frequency regulation services, we are accounted for as a development stage company under Statement of Financial Accounting Standards No. 7. We maintain our principal offices, research and development laboratory and manufacturing facility at 65 Middlesex Road, Tyngsboro, MA 01879. Our telephone number is 978-694-9121.

        We file annual, quarterly and current reports, proxy statements and other information with the U.S. Securities and Exchange Commission (the "SEC"). You may read and copy any documents that we file at the SEC's public reference room at 100 F Street, N.E., Washington, D.C. 20549. You may call the SEC at 1-800-SEC-0330 for further information on the public reference room. Our SEC filings are also available to the public free of charge at the SEC's Web site at www.sec.gov.

        Our Web site address is www.beaconpower.com. All of our filings with the SEC, including annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and all amendments to those reports are made available free of charge on our Web site as soon as reasonably practical after being filed electronically with, or furnished to, the SEC. The content on our Web site does not constitute part of this annual report. We also make available our Corporate Governance policies and our Code of Conduct on our Web site. Additionally, paper copies of these documents may be obtained free of charge by writing our Investor Relations Department at our principal executive office.

        The focus of our research and development has been to establish commercially viable flywheel-based energy storage technologies that can provide highly reliable energy solutions for the worldwide electricity grid at competitive costs. Initially, we expect to generate revenues from the commercialization of our flywheel energy storage systems to supply frequency regulation services to the electricity grid in North America. We believe that as we expand our production capabilities we can become a provider of frequency regulation services to grid operators on a global basis. In addition we believe that as the commercialization of our technologies continues, we will develop other cost-effective applications for our flywheel systems that will provide additional revenue opportunities.

        Our market focus is on the geographic regions of the domestic grid that provide open bid markets for regulation services. These regions and their Independent System Operator (ISO) or Regional Transmission Operator (RTO) designations are: New England (ISO New England or ISONE); California (California ISO or CAISO); New York (New York ISO or NYISO); Mid-Atlantic (PJM Interconnect) and Texas (ERCOT). In addition, during 2008 Midwest Independent Transmission System Operator, Inc. (Midwest ISO or MISO) is expected to begin operating its open-bid ancillary services market for frequency regulation. We have been proactive in this emerging market and have added it to our initial target markets.

        These regional ISOs/RTOs or grid operators purchase frequency regulation services from independent providers in open bid markets that they manage and maintain. We are seeking to become one such provider. We believe our technology will offer grid operators the benefits of greater reliability; faster response time; cleaner operation, including zero direct emissions of carbon dioxide (CO2),

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nitrogen oxide, sulfur dioxide and mercury; and lower maintenance costs compared to conventional power generation facilities that also provide frequency regulation services. We believe that we will have lower operating costs and faster response time than the majority of other entities that provide frequency regulation services, which we believe will allow us to have sufficient margins to make the company economically viable.

The Frequency Regulation Market

        Levels of power supply and demand on the power grid change from second to second and minute to minute. The need to balance electricity supply and demand on the grid requires a special service to maintain stable power frequency called frequency regulation. Deviations from nominal grid frequency can have a negative impact on the operability of devices that obtain power from the grid. In North America, grid frequency is maintained at 60 cycles per second (Hertz, or Hz). In Europe and other parts of the world, the same requirement exists for balancing power supply and demand on the grid, but at a frequency of 50 Hz. In North America, the effectiveness of maintaining grid frequency is measured by performance standards provided by the North American Energy Reliability Council (NERC). Financial penalties can be imposed on grid operators when performance standards fall below levels deemed acceptable. Similar standard-setting entities for frequency regulation exist in most other parts of the world.

        In North America, the frequency regulation market in areas that were accessible via open-bid auction mechanisms was valued at approximately $800 million in 2007. Before the end of 2008 (by which time Midwest ISO's regulation market is expected to be in operation) the addressable open-bid regulation market on an annualized basis is expected to exceed $1 billion per year. Based on global electrical production, we believe that the worldwide frequency regulation market is several times this amount. Significant growth in the US open-bid market is expected due to a combination of factors, including:

    Greater use of renewable energy sources—especially wind generation and solar

    Anticipated expansion of open-bid grid operating regions such as the Midwest ISO

    Increased demand for electricity

    Increased natural gas prices.

        Under the open-bid market, grid operators forecast the need for frequency regulation as a percentage of expected power demand, and approved suppliers submit bids for these services. Bids are stacked from lowest to highest prices until the cumulative amount of bids is sufficient to meet the calculated need. The price submitted by the highest selected bidder determines what every bidder is paid.

        To fully exploit this regulatory-driven open-bid market, we are finalizing our design and expect to build, own and operate a number of frequency regulation facilities. Our business model, which is a sale-of-services model, is similar to that of independent power producers who also design, build, own and operate their own power plants. Each Smart Energy Matrix™ frequency regulation facility will be up to 20 megawatts (MW) in size. A Smart Energy Matrix™ is a multi-flywheel energy storage system designed to provide reliable and sustainable frequency regulation services for utility grids. A Smart Energy Matrix™ can be scaled to any size to provide one or more megawatts of frequency regulation capacity. Smart Energy Matrix™ frequency regulation plants that are 20 MW or less in size offer the advantage of being eligible to use fast-track interconnection regulations that allow plants of this capacity or smaller to be approved more quickly in accordance with streamlined regulatory rules. A key aspect of our business model is that we are not dependant on the lengthy procurement cycles typically associated with the marketing and sale of capital equipment to the utility sector. Instead, our business model is to become a merchant provider of frequency regulation services to the deregulated open bid

2



markets. We will be bidding the output of our plants into multiple open-bid markets for regulation services on a daily basis.

        A key qualification for our participation in these markets is the ability to demonstrate that our technology can deliver the regulation services required by each grid operator. To attain this qualification and accelerate market entry we installed two scale-power 100-kilowatt (kWh) demonstration models of our Smart Energy Matrix™ for evaluation by two large grid operators. Both of our scale-power systems were comprised of multiple flywheels. In 2005, we were awarded contracts for these systems by the California Energy Commission (CEC) and the New York State Energy Research and Development Authority (NYSERDA), in cooperation with the U.S. Department of Energy (DOE), to test the viability of our flywheel technologies for frequency regulation by these grid operators. The demonstration systems were scale-power prototypes of the Smart Energy Matrix™ multi-flywheel system. As a result of the success of the pilot programs, we have focused on the design of the full scale Smart Energy Matrix™ systems.

        Both the California and New York systems were installed and evaluated in formal field trials. The demonstration units contained fully-functional control, communication and interconnection elements similar or identical to the elements of our design for 20 MW frequency regulation facilities. The purpose of these pilot systems was twofold: 1) to demonstrate the ability of our flywheel technology to provide frequency regulation services consistent with the technical requirements of the grid operators, including the California ISO and New York ISO, and 2) to obtain certification or other approval from these system operators that, from a technical perspective, our technology is approved to provide commercial frequency regulation services in their respective states and territories.

        The California system completed its field trial on January 31, 2007, earning a positive evaluation from both the CEC and the CAISO. On December 26, 2006, the California ISO certified our flywheel technology for use as a frequency regulation resource in California.

        The New York demonstration unit incorporated technology improvements as a result of field testing in California and the system contained additional voltage support and power quality capabilities. The added capabilities were designed to demonstrate the technical efficacy of two entirely new applications for our core technology.

        On March 22, 2007, the New York State Energy Research and Development Authority (NYSERDA) and the U.S. DOE confirmed the successful outcome of field trial testing of our scale-power flywheel frequency regulation system in New York. At the same time, the New York ISO determined that our technology is a viable technology for frequency regulation on its grid and is acceptable for provision of commercial frequency regulation in the State of New York. Our New York-based flywheel system field trial reached this significant milestone after the U.S. DOE (through Sandia National Laboratories, which co-monitored the demonstration with NYSERDA) concluded that the unit's performance had been successfully demonstrated and that additional testing was not required. During the next several months the New York demonstration unit will be retrieved for potential future use in supporting other demonstration programs and/or R&D activities.

        We believe the performance characteristics of the Smart Energy Matrix™ will match the requirements of the frequency regulation market quite well. The Smart Energy Matrix™ recycles excess energy when generated power exceeds load and delivers it when load increases. We will be able to provide a response time that is up to 100 times faster than incumbent generators providing this service.

        We believe that our operating cost structure will be significantly lower than most incumbent frequency regulation service providers. Our Smart Energy 25 flywheel is being designed to operate with low energy losses, minimal mechanical maintenance for 20 or more years and without significant degradation in energy conversion efficiency. In particular, our technology is different from incumbent frequency regulation providers in that it does not use fossil fuel. Fossil fuel is the largest variable cost

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for most competing frequency regulation providers. Because our Smart Energy Matrix™ does not burn fossil fuel, we believe our cost structure is largely insulated from the negative impact of price increases for coal, oil and natural gas. Historically, wholesale energy prices have a strong correlation with market prices for frequency regulation. Consequently, as the price of energy rises, we believe that the pricing per megawatt service hour for frequency regulation can generally be expected to rise, but without a proportional increase in our operating cost.

        Since it does not burn fuel, the environmental benefits of our technology are significant. Our technology's ability to reduce carbon dioxide (CO2) emissions was studied by KEMA, Inc., an international energy industry consulting firm that was commissioned to evaluate the potential of our technology to reduce greenhouse gas and other emissions. The KEMA study indicated that compared to conventional fossil-fuel based frequency regulation providers our technology is estimated to produce up to 89% less CO2. The study indicates that the dramatically cleaner performance of our flywheel systems (as contrasted to frequency regulation services supplied by fossil fuel companies) can be expected to offer significant value to regulators, grid operators, and utilities facing increasing demands to lower CO2 emissions.

        The location of our regulation plants and the sequence in which they will be constructed depend on a number of factors, including but not limited to the availability and cost of land, the cost of power plant construction, technical grid interconnection requirements, comparative market pricing available for frequency regulation in the various regional markets, and our ability to receive appropriate revenues and payments within the Market Rules of each regional market.

        Pending the expected approval of a land-use permit we have requested from the town of Stephentown, New York, and approval of our active interconnection request to NYISO, the location of our first 20 megawatt frequency regulation plant will likely be in Stephentown. We are aggressively pursuing completion of the required interconnection processes for Stephentown. There have been hearings in the local community regarding the necessary building and environmental permits, and the process is progressing as we expected.

        We have an option to purchase approximately seven acres of land at the Stephentown site. This site is served by two transmission companies: National Grid and New York State Electric and Gas (NYSEG). National Grid owns a 115 KVA transmission line that abuts the site, and NYSEG owns a substation that also abuts the site. Our interconnection request for a 20 MW plant includes National Grid as the transmission provider.

        We have changed our implementation schedule that had anticipated revenues from one megawatt of service in one location beginning in April 2008. We expect to have a maximum of five megawatts of capacity in place in New York by the end of 2008, and the plant would reach its full 20-megawatt capacity during 2009. We have also initiated the permit process to establish up to five megawatts of frequency regulation capacity at our Tyngsboro site, and we have identified and are pursuing two potential locations in the PJM region.

        There are two primary reasons for the revised deployment schedule:

Component development and quality:

      We are completing development of some components to ensure highly durable operation at commercial operating speeds.

      To achieve our business plan over the next few years, we have taken actions to develop multiple sources for our key components. We have been working with our expanding supplier base to qualify their components to our designs and specifications, so that we may complete the initial production run of Smart Energy 25 flywheel units.

4


        Initial components were received from suppliers that have been adapting their production processes to meet our component requirements. Following extensive inspection and qualification testing, we determined that certain vendor-supplied components did not meet specifications. We are continuing to work closely with our suppliers to refine their manufacturing processes and ensure quality results.

        Upgraded components have begun to arrive from primary and secondary suppliers and will be integrated into the production certification process prior to deployment at commercial locations.

Market rules and participation:

      To participate in and be paid for regulation services in our target markets, certain conditions must be met. The technology must be demonstrated and accepted by the Independent System Operators (ISOs). We accomplished this through our successful demonstration projects in California and New York.

      We must become a member of each ISO, and confirm that market rules specific to each ISO are compatible with our technology. We have been a member of the PJM Interconnection since 2004 and we have found no restrictions to market participation there. More recently, we have been accepted as a member of ISO New England, and we have also applied for "customer" status with New York ISO.

      The grid interconnection process within our target markets requires more time to complete than we had previously thought and in some cases market rule changes are required which also require time to complete. Some ISOs (other than PJM) have not yet updated their market rules to comply with the Federal Energy Regulatory Commission's 2007 mandate that non-generation resources (such as ours) be allowed equal access to enter the market for regulation services. It is believed that these ISOs will require a number of months to come into compliance, and we have added more resources to accelerate the process.

        We completed the move to our new facility in January 2008, and we have completed the first phase build-out of our manufacturing facility. We now have a facility capable of producing up to 600 flywheels per year, which will be ramped up to commence all aspects of production once the development of all components is complete. We have a second phase manufacturing build-out planned which will increase annual manufacturing capacity to more than 1,000 flywheels.

        Because our business model is based on being a service provider that owns and operates plants and equipment as opposed to selling equipment, we will need to obtain significant additional funding to further expand our manufacturing capacity, procure flywheel components for manufacture as well as ancillary equipment and construct frequency regulation facilities. We expect to raise additional capital in 2008 through the sale of stock in the Company. In the future, as the number of our regulation facilities increases and we develop a history of sustained cash flows, we expect to fund additional plants from a combination of non-recourse project finance, debt, project equity and available cash flow from existing regulation facilities.

Regulatory and Market Affairs

        Within each ISO there is a market tariff and set of market rules that determine who is allowed to bid into regulation markets, how much regulation providers are paid for their services, and what costs providers must pay to participate in markets. While three ISO's have certified or otherwise approved our flywheel technology for commercial deployment, each ISO has its own market rules that will govern the pace at which markets are opened and the degree to which our technology is allowed to participate. Historically, the market rules for regulation were written to conform to traditional generators' abilities

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to provide regulation. This is understandable, because until the advent of our technology, the capabilities and limitations of traditional generators defined how regulation could be technically implemented. In the markets in which we intend to compete, most of the ISO market rules still contain legacy terms, performance characteristics and other requirements that do not match our new technology. The impact of this mismatch varies from market to market, and our ability to foster beneficial changes to ISO market rules will determine our timing for entering these markets and building regulation facilities, as well as the revenues and costs associated with each market.

        Of considerable importance and benefit to us, on February 16, 2007, the Federal Energy Regulation Commission (FERC) issued a landmark ruling, Order 890, Preventing Undue Discrimination and Preference in Transmission Service. This FERC ruling seeks to promote greater competition in electricity markets and strengthen the reliability of the grid. Included in Order 890 was a mandate by FERC that all ISOs must change their market tariffs to allow non-generation resources (such as ours) capable of providing frequency regulation the ability to bid and sell into these markets. The ruling also stated that market rule changes must be implemented in a completely non-discriminatory manner.

        We believe that FERC Order 890 will accelerate the pace of market rule changes and we have already made progress with several of the ISOs by working with them directly to implement changes to market rules. We are already experiencing positive effects of Order 890 in the form of heightened commitments by ISOs to work collaboratively with us to integrate our technology to their grids. To insure that we have the right resources to properly address the timely opportunity represented by FERC Order 890, we obtained expert regulatory and legal counsel and have put a vigorous regulatory affairs program in place.

        In January 2008, our principal regulatory affairs consultant, Judith Judson, joined us as Director of Regulatory Affairs and Markets. Ms. Judson brings with her a wealth of experience in electric utility regulation, market development, policymaking and business management. Prior to joining us, Ms. Judson worked in Massachusetts state government from 2003 through early 2007, where she rose to become the state's head energy and telecom regulator and worked with stakeholders across government and private industry to create new wholesale electricity markets in New England and develop a comprehensive state energy policy focused on conservation and renewable technologies. In addition, she served as Chairman of the state's Energy Facilities Siting Board, overseeing the siting of new energy transmission, distribution and generation.

        As a result of FERC Order 890, all ISO's were required to submit a compliance filing with the FERC in October 2007 to define their degree of compliance with this mandate. Once the ISO compliance filings were published, we became an active participant in reviewing these ISO filings and providing input to FERC. We determined that most of the ISOs were deficient in some way with respect to full Order 890 compliance. In November 2007 we intervened with FERC and submitted comments on each of the ISOs' Order 890 compliance filings in an effort to ensure that our technology is allowed to fairly participate in each of the markets, earn revenues in proportion to the true value of services provided and incur no more than a fair share of costs for market participation.

        These FERC regulatory proceedings are ongoing. The current status of each ISO market is as follows:

    PJM amended its tariff language to comply with Order 890 and stated that its current rules allow non-generation resources like ours to fully participate in its Regulation and Frequency Response market. We believe PJM's market rules allow us to enter the market any time we choose to do so, subject to normal arrangements for interconnection, financing, zoning and so forth.

    NYISO postponed submitting a new tariff and market rules to allow non-generation resources and instead stated that we can qualify under the existing tariff as a generator. While we can

6


      enter the market within the generator category, we believe this category might expose us to unwarranted costs and potentially reduce our revenues. In its November 19, 2007 response to our comments to NYISO's Order 890 Compliance Filing, NYISO noted that: "The NYISO is currently working with Beacon to ensure that software and metering arrangements are in place to support its participation in the markets as a generator when its facility actually comes on line, which is expected to occur sometime next year [2008]. There is, however, no tariff obstacle to Beacon's provision of regulation service." Our regulatory focus includes working with NYISO to remedy certain limitations we see within the generator category, and/or to switch categories and become qualified under a newly emerging category called Demand-Side Ancillary Service Program (DSASP). This new DSASP category is expected to become operational before the end of 2008 and could, we believe, remedy certain deficiencies that may be associated by qualifying within the generator category. Another option for us would be to enter the market under the generator category, but switch categories once the new DSASP category becomes effective.

    ISONE modified its tariff language but stated that it needed to make changes to market rules in order to fully comply with Order 890. Those market rule modifications are currently under active development with our input, and we believe that ISONE has the potential to achieve effective compliance with Order 890 before the end of 2008.

    CAISO did not submit changes to its tariff to comply with Order 890, but clearly acknowledged to FERC its need to do so. We expect CAISO to begin the process of making these market rule changes in 2008. CAISO has been strongly supportive of the evolution and value of our technology with respect to its ability to integrate renewable energy sources, especially wind, and we believe that CASIO's market rule changes also may result in a performance-based tariff that rewards fast-response regulation resources, including our flywheel technology.

    Midwest ISO is in the process of implementing a new Ancillary Services Market (ASM) to meet its compliance requirements with Order 890. We are actively engaged with MISO in the development of this market. This new ASM is in a testing phase and is expected to start in July 2008. While the market generally contains features that would allow us to compete, several features of the market could have the impact of increasing our costs and/or decreasing revenues in what we believe would be a discriminatory manner. In response to our FERC filing to draw attention to these issues, on February 25, 2008, the FERC issued its decision with respect to MISO's ASM tariff. FERC responded positively to the issues we raised in our Initial and Reply Comments. Specifically, FERC indicated its willingness to consider alternatives to co-optimization requirements and agreed with our assessment about the need for market-based rates. FERC commented: "We require the Midwest ISO to evaluate, through stakeholder discussions (we consider discussions between the Midwest ISO and Beacon Power to be the most appropriate venue for determining whether new technologies qualify as generation resources) adjustments to operating requirements and ASM procedures that will remove barriers to comparable treatment of DRRs and new technologies in the regulating reserve markets and to provide a report on its efforts to incorporate these resources into its markets within 60 days of the date of this order. We also require the Midwest ISO to submit revised tariff sheets, if adjustments are proposed, in a compliance filing to be submitted concurrently with the 60-day informational filing."

    ERCOT's market prices for regulation currently do not support market entry. Since ERCOT is not regulated by the Federal Energy Regulatory Commission, our ability to seek beneficial market rule changes that hold the potential to support higher pricing in consideration of our technology's superior performance is limited at this time. As the performance of our technology is fully demonstrated at a system-wide level in other ISOs, and as wind penetration in Texas increases and the demand for fast regulation resources rises, we will re-evaluate the feasibility of

7


      encouraging beneficial market rule changes and the potential of entering this market on a more profitable basis.

Defense applications

        We are in the design phase for a flywheel energy storage system for satellites capable of achieving maximum theoretical specific energy density. The program is jointly funded by the Air Force Research Lab (AFRL) and the Defense Advanced Research Projects Agency (DARPA). We believe that our high-energy flywheel technology is increasingly attractive as a platform for power regulation of micro-distribution systems typical of space platforms, navy vessels and other military hardware. We are actively pursuing defense and military-related projects that, in addition to generating revenue to help cover operating costs, effectively provide non-dilutive R&D funding for key technology innovations and advancements that can be transferred to commercial markets.

Other Flywheel-based Market Opportunities

        Other applications for which we believe our technologies may be well suited include:

    Reactive power support (VAR support)

    Angular stability control

    Ramp mitigation

    Voltage support for rail systems

    Peak power support (load balancing)

    Stabilization of distributed generation systems

    Uninterruptible power supply (UPS).

        We are evaluating these additional applications to determine whether they represent commercially attractive market opportunities; however, our focus in the near term will be to deploy company-owned flywheel facilities for the frequency regulation market.

Competition

        In the frequency regulation market, we believe our Smart Energy Matrix™ will offer superior performance and cost benefits over incumbent fossil fuel and hydro-powered generators. These incumbent generators can supply frequency regulation if they are willing and able, on short notice, to increase or decrease generation of a specified amount during a specified period. Participating generators both sell electricity in their role as generators, and sell frequency regulation services using some of their reserve generating capacity. Providing regulation services is qualitatively different than generating electricity because the generator's output varies constantly in response to continually changing signals from the grid operator, it is priced differently, it carries a different cost structure, and therefore it is sold through a different market within the ISO.

        Not all generators provide frequency regulation services. Some, such as nuclear power plants, are unable to vary their output in the manner needed to participate in this market. Others may be capable of providing such services, but choose not to do so. Many generators prefer to sell electricity and not provide frequency regulation services, due to the higher operating and maintenance costs that arise from providing frequency regulation as compared to the steady generation of electricity. The constant up and down of supplying frequency regulation services is hard on their equipment. Fossil fuel generators suffer more wear and tear from this process than do hydro-powered generators.

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        Most bidders in the frequency regulation auctions are fossil fuel generators. Fossil fuel generators are subject to increasing fuel prices and high operating and maintenance costs arising from ramping equipment up and down to supply frequency regulation services. They are also affected by opportunity costs that arise from using generating capacity to provide frequency regulation services rather than to produce the maximum amount of electricity for the grid. Although hydro-powered generators have lower operating and maintenance costs than fossil fuel producers, they are geographically limited. Compared to the fossil fuel generators, our Smart Energy Matrix™ will have much lower operating and maintenance costs and minimal fuel costs. Consequently, we believe that we will be a successful bidder to provide frequency regulation services to regional grid operators that utilize auction markets.

        We also believe that, given the demands of providing frequency regulation, other forms of energy storage such as batteries, lower energy flywheels, fuel cells and electrochemical capacitors will not be able to cost-effectively compete with the Smart Energy Matrix™. For example, batteries have a short economic life and are generally not environmentally attractive. Metal flywheels cannot store as much energy as can our composite flywheels, because they cannot spin as fast without incurring a significant weight, size and cost penalty. Composite flywheels of other companies known to us have only a fraction of the energy required to provide the service, as compared to our flywheels.

Discussion of Operations

        We have experienced net losses since our inception and, as of December 31, 2007, had an accumulated deficit of approximately $163 million. We are focused on the development and commercialization of our Smart Energy Matrix™ flywheel system for frequency regulation and completion of our research and development contracts. We do not expect to have positive EBITDA (earnings before interest, taxes, depreciation and amortization) or positive cash flow until at least 2010 and must raise additional equity and debt to execute our business plan and continue as a going concern. To achieve our objectives on EBITDA and cash flow we will need to obtain sufficient funding through a combination of equity and debt to commercially install the number of frequency regulation plants included in our business plan. In the event that we are not able to deploy plants as planned due to capital constraints, positive EBITDA and cash flow would be delayed.

        In 2008 and beyond we will need additional funding to expand our manufacturing capabilities and to build and install frequency regulation facilities in accordance with our business plan. We expect to raise the required capital in 2008 through the sale of stock in the Company. In the future, as the number of our regulation facilities increases and we develop a history of sustained cash flows, we expect to fund additional plants from a combination of non-recourse project finance, debt, project equity and available cash flow from existing regulation facilities.

        In October, 2007, we were notified by the U.S. Department of Energy (DOE) that we were selected to submit a full application for a DOE program that would provide loan guarantees for up to 80% of the project debt needed to finance the construction of our first 20-megawatt flywheel frequency regulation plant. We were one of only 16 companies similarly invited to apply, from a total of 143 that filed "pre-applications" for loan guarantees, and the only company whose project was chosen in the Electricity Delivery and Energy Reliability category. Although the DOE program permits the grant of guarantees of up to 80% of project costs, we do not expect to achieve as high a percentage. We are hopeful, however, that we will be able to finance the majority of our first 20MW facility from debt guaranteed by the DOE. However, the application process is not complete, and we have not been provided with any loan guarantees from the DOE. There is no assurance that we will be successful in obtaining a loan guarantee under the DOE program, or if awarded, that it will be for as high a percentage of the project costs as we would have liked or that the loan will be offered with terms and conditions that are acceptable to us. The timing of any such guarantee-backed loans is also uncertain, and even if granted, it is conceivable that the timing for processing any such guaranteed loan may preclude its practical use in financing our capital projects. If we are not successful in obtaining such

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DOE support on a timely basis for the 20MW facility at Stephentown, we may need to seek additional capital through the sale of common stock or delay our deployment schedule.

        Since our inception in 1997 we have funded our development through private equity and the sale of common stock. In November 2000, we completed our initial public offering, raising approximately $49.3 million net of offering expenses. In 2005, we raised approximately $17.1 million via private placements of common stock. During 2007, we raised approximately $42.6 million, net of offering expenses, as a result of three financings. In the first quarter of 2007, we raised approximately $9.6 million through the sale of common stock in a private placement. In the third and fourth quarters, we raised approximately $9.2 million and $23.8 million, respectively, through the sale of common stock and warrants pursuant to a shelf registration statement. We believe that the capital raised in 2007 will provide sufficient funding for us to continue to implement our business plan into the fourth quarter of 2008.

        Our profit and losses as well as uses of cash may fluctuate significantly from quarter to quarter due to fluctuations in revenues (if any), costs of development, inventories, receivables, and the market price for regulation services. In addition, cash may fluctuate by period due to the timing of capital expenditures for expanding manufacturing capabilities or construction of frequency regulation facilities and the related timing of project financing or equity raises. These fluctuations in cash requirements could put additional pressure on our cash position. There can be no assurance that we will be able to raise the required capital on a timely basis or that sufficient funds will be available to us on terms that we deem acceptable, if they are available at all.

Approvals and Certifications

        In 2007 both PJM Interconnection and the New York ISO (NYISO) certified or otherwise approved our technology for commercial use in providing frequency regulation within their respective regions. As previously noted, on December 26, 2006, the California ISO certified our flywheel systems for use as a frequency regulation resource in California.

        In prior years, we have obtained Underwriters Laboratory approval for our existing 2-kWh and 6-kWh Smart Energy flywheel products and we have received certification that our smaller Smart Energy flywheel systems meet Telcordia standards, which are the baseline for performance and safety standards established by the telecommunications industry. Our 2-kWh and 6-kWh Smart Energy products are, to our knowledge, the only flywheel products that have passed a Zone 4 earthquake test while operating, making them suitable for use anywhere in the United States. We also expect to test our commercial frequency regulation system with the Zone 4 earthquake test. Our Smart Energy flywheel systems have been successfully tested for compliance with the Institute of Electrical and Electronics Engineers (IEEE) 587 standards, which is the required standard for all Uninterruptible Power Supply systems.

        In prior years we have also obtained Underwriters Laboratory approval for our Smart Power M5, M5 Plus, M4 and M4 Plus solar inverter systems. The California Energy Commission and New York's Public Service Commission have also approved these products for on-grid applications.

Our Technology

Flywheel-based products

        Our patented composite flywheels offer superior reliability and performance at competitive costs compared to other energy storage devices. Our composite flywheel is a rotating wheel on hybrid magnetic bearings and operates in a near-frictionless vacuum-sealed environment. The flywheel is powered up to its operational speed using a permanent magnet motor and electricity from an external power source (typically the grid). When the composite rim spins, it stores energy kinetically. The

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flywheel is able to spin for extended periods with great efficiency because friction and drag are virtually eliminated by the use of hybrid magnetic bearings and a vacuum-sealed environment. Because it has very low friction, little power is required to maintain the flywheel's operating speed. When electrical power is needed, the momentum of the spinning flywheel drives a generator and its bi-directional inverter converts the kinetic energy into electrical energy.

        Our products employ enabling materials such as high-strength fiber, efficient electric drives, and low-loss, long-life bearings to create new generations of flywheel products. Our composite flywheels are fabricated from a proprietary mixture of high-strength, lightweight fiber composites, such as graphite and fiberglass combined with resins, which allow the flywheel to rotate at high speeds and store large amounts of energy relative to similar size and weight flywheels made from metals.

        Our products employ an internal rather than external vacuum system and its bearing systems have been designed and developed to need low scheduled replacement or maintenance. In contrast, many competing flywheel products rely on bearings and external vacuum systems that require periodic maintenance and replacement. Our Smart Energy flywheel systems have dramatically longer discharge times than any other flywheel energy storage systems known to us; this is possible because our technologies result in higher amounts of stored energy and minimal energy losses during operation.

Research and Development

        Our research and development efforts are essential to our ability to successfully design and deliver commercial products, as well as to modify and improve existing products to reflect the evolution of markets and customer needs while reducing our costs. Our engineers work closely with potential customers to define product features and performance requirements to address specific needs for both flywheel-based solutions and renewable energy applications. Research and development expenses, including engineering expenses, were approximately $8,387,000 in 2007, $4,748,000 in 2006 and $1,408,000 in 2005. We expect research and development expenses in 2008 to be higher than those in 2007 due primarily to the costs of improving the performance of the Smart Energy 25 flywheel, cost reduction design work and design of the facility for deploying our systems. Our headcount on December 31, 2007 was 44 which included 20 engineers and technicians and six manufacturing employees. In addition, we utilized the services of a number of independent contractors primarily engaged in research and development and design work on manufacturing and frequency regulation facilities, as well as market rules and evaluation of competitive features of each ISO.

Renewable Generation Integration Project

        Before the end of April 2008, we expect to begin providing contract services for a wind-related R&D project co-funded by the California Energy Commission, identified as CEC-PIER Contract 500-07-020, Agents for Renewables Project. The objective of the project is to find better ways to coordinate and maximize energy production and delivery from wind generation resources located in the Tehachapi area of California. The technical approach will include the application of "intelligent agent" controls and Beacon's flywheel energy storage in an effort to find ways to deliver as much wind energy as possible without exceeding the dynamic ratings limits of the locally-constrained transmission system. "Intelligent agent" control technology has been identified as a key element of the DOE SmartGrid initiative and is often defined as an advanced control technology that executes autonomously, operates in real-time, communicates with other agents or users, exploits domain knowledge, and exhibits goal-oriented behavior.

        We will support the project's prime contractor, Alternative Energy Systems Consulting, Inc., with the design, development and demonstration of an agent-based system that:

    Controls flywheel storage technology to improve the dynamic control of wind generation resources, and

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    Coordinates energy production and delivery from wind generation in the Tehachapi region of California.

        Project partners include Southern California Edison and the California ISO. The project will re-use the existing flywheel scale-power demonstration system owned by the CEC and tested for regulation on PG&E's grid in 2006/7. Our share of the scope of work is valued at $312,676, of which we will receive $250,000 from the CEC and provide matching funding of $62,676.

        Another goal of the project is to identify ways to commercialize any new application that may be developed. This project R&D is exploratory and there can be no assurance that a commercially-feasible application will be developed. However, this project is consistent with our interest in potential applications that have a high cyclic requirement, move a large amount of energy through the flywheel matrix, potentially address a large global market, and facilitate renewable energy, which in this case is wind power.

Manufacturing

        We moved from our Wilmington, Massachusetts facility to our new corporate headquarters in Tyngsboro, Massachusetts. The Tyngsboro facility, for which we signed a seven-year lease in July 2007, significantly expands our manufacturing capacity and provides sufficient space to continue our research and development activities. Our new facility is located at 65 Middlesex Road, Tyngsboro, MA. The 103,000 square foot facility, which was fully renovated and built-out to our specifications, has a manufacturing capacity of more than 600 flywheels per year, although such commercial scale manufacturing will await completion of the development work now underway, targeted at ensuring highly durable operation of the flywheels at commercial speeds. The manufacturing capacity of the facility can be further expanded to over 1,000 flywheels per year when necessary.

        We expect to continue to expand staffing for the assembly and testing of our flywheel systems during 2008 and beyond. In addition to assembly work at our Tyngsboro facility, we rely on outside suppliers to provide components for our systems. For our mechanical flywheel systems and the related electronics, we are working to establish a minimum of two suppliers for each component to reduce any adverse impact of a loss or interruption by a supplier.

        In 2006 and 2007 we also assembled and tested a small quantity of Smart Power M-series inverters at our facility. We believe we have adequate vendor sources for all the components of the Smart Power M-series inverter systems. Although we are continuing to support our inverter products, we do not believe that inverters will be a significant portion of our business going forward and we are uncertain as to when or at what price we will be able to sell our inventories, which are carried on our balance sheet at no value.

Sales and Marketing

        In 2007, sales and marketing activities for our flywheel-based frequency regulation services were focused on obtaining additional certifications to operate our technology in deregulated open bid markets on a commercial basis. The California ISO provided its certification in December 2006, and further validation of our technology and market acceptance followed with certifications or acceptances from New York ISO in March 2007 and PJM Interconnection in June 2007. PJM Interconnection is the world's largest competitive electricity market.

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        We expect that sales and marketing activities will expand in 2008 as we seek other certifications or approvals to operate in open bid markets in addition to the three regions noted above. In particular, the Midwest ISO's open bid regulation market is expected to start before the end of 2008. Simultaneously, we are assessing the comparative value of all the open bid markets in order to determine in which markets and in what sequence our merchant facilities should be built and brought on-line.

        Consistent with our focus on participating in multiple deregulated open bid markets in the near-term, we have increased our level of involvement in regulatory affairs on both a national and regional level. As noted elsewhere, we have added a Director of Regulatory Affairs and Markets to lead those efforts. We joined the North American Electric Reliability Council (NERC) at the beginning of 2007, and we increased participation in regional ISO events related to becoming a market participant in various ISOs. We have continued our membership in the PJM Interconnection, joined ISO New England as members and applied for "customer" member status in New York ISO. We also plan to seek membership in the Midwest ISO and CAISO before the end of 2008.

        During 2008 we expect to expand resources dedicated to identifying and perfecting plant sites in multiple ISOs to provide the option to build plants in those ISOs as market pricing and other factors present the right opportunities. We plan to further refine our assessment of the European market for regulation, and we will look for opportunities to demonstrate our frequency regulation technology on a live grid in Europe, and we will also be evaluating the market potential for our systems on islands around the world, for example, Hawaii and New Zealand.

Backlog

        At December 31, 2007, we did not have any firm commercial sales commitments for our products and services. We have one ongoing research and development contract from which we expect to derive final revenue in 2008 of approximately $11,000.

Customer Service

        We expect to provide maintenance and support for our products by utilizing our own customer service personnel as well as support as needed from our engineering organization. In the future, we may elect to contract all or part of the customer service activities to outside sources if we deem it effective from both a customer satisfaction and an overall cost perspective.

Intellectual Property

        Our success depends upon our ability to develop and maintain the proprietary aspects of our technologies and to operate without infringing on the proprietary rights of others. To some extent, our success also depends upon the same abilities on the part of our suppliers.

        We rely on a combination of patent, trademark, trade secret and copyright law and contract restrictions to protect the proprietary aspects of our technology. We seek to limit disclosure of our intellectual property by requiring employees, consultants, and any third parties with access to our proprietary information to execute confidentiality agreements and by restricting access to that information. Our patent and trade secret rights are of material importance to our current and future prospects. We are actively pursuing both national and foreign patent protection.

        The intellectual property rights of our flywheel-based products are primarily embodied in patents that we hold or which are pending, but in addition include flywheel technologies and patents that we are licensed to use in perpetuity. We hold U.S. patents on our flywheel vacuum system, heat pipe cooling system, output paralleling algorithm, metal hub, low-loss motor, co-mingled rims, earthquake-tolerant bearings and bearing cooling device. In February 2007, we received our first foreign patent, in

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Australia, on our vacuum system, and an additional U.S. patent, on a bearing damper. Our patents, including our Australian patent, expire on various dates between 2020 and 2021. We also have 20 pending U.S. and foreign patent applications, and several other applications being prepared for filing. We hold a perpetual, exclusive, royalty-free, worldwide license by SatCon Technology Corporation to use its flywheel technologies and patents for stationary terrestrial flywheel applications. This license includes 11 issued U.S. patents and 11 U.S. and foreign patent applications that expire on various dates between 2012 and 2021 and covers SatCon's technologies and patents and all improvements made by SatCon through November 16, 2000, the date of our initial public offering. We are not entitled to any improvements to the flywheel technology that SatCon develops subsequent to that date. We expect to develop additional intellectual properties and trade secrets as we continue developing additional Smart Energy and Smart Power systems. We own all technology improvements that we have developed that are based on the technology licensed from SatCon.

        See also Item 3, "Legal Proceedings", below, regarding a lawsuit brought against us, alleging patent infringement.

Government Regulation

        We expect to be a substantial beneficiary of any government deregulation of North American and other electricity markets. In the U.S., in particular, the open-bid market for frequency regulation services reflects a set of market rules that define how suppliers of regulation are able to access these revenue-producing markets without the need to sell equipment to traditional end-use customers. These open market environments have the potential to provide us a rapid growth in revenue using our high-energy carbon composite flywheel technology and our merchant plant business model. See also "Regulatory and Market Affairs" for further discussion of how government regulation affects our business.

Employees

        At December 31, 2007, our headcount was 44 full-time employees, three part-time employees and a number of independent contractors. Our staff included 26 technical employees made up of engineers, technicians, and production workers involved in research and development and low rate initial production (LRIP). We also had two employees in sales, marketing, business development and customer service. The remaining sixteen people were involved in administrative tasks. None of our employees is represented by a union and we consider our relations with employees to be satisfactory.

Item 1A.    Risk Factors Relating to Our Business

We face significant technical challenges in completing the development of the Smart Energy Matrix™. We may fail to develop our 25kWh generation flywheel system to a commercial production design, which is a critical requirement for the development of the Smart Energy Matrix™ and, even if we are able to develop the 25kWh system, we may fail to develop the Smart Energy Matrix™.

        Although we have successfully developed three high-energy flywheel systems (the 2kWh and 6kWh for telecom and the 6kWh for the grid) that had similar technical challenges, there can be no assurance that we will be able to successfully complete development of the 25kWh system. The successful development of our Smart Energy 25 flywheel system, which will be used in the Smart Energy Matrix™, involves significant technological and cost challenges, including:

    Timely development of cost-effective designs for key components of the Smart Energy Matrix™, such as the flywheel hub

    Prototype test malfunctions could result in damage to our other equipment and test facility, re-engineering costs and production delays

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    Development and production delays and/or cost increases may occur if we are unable to establish multiple source suppliers for key components that meet our engineering requirements, cost objectives, and development and production schedules

    Development of cost-effective designs on schedule that will meet system performance requirements such as:

                •    A rotor-cooling scheme to avoid overheating during operation

                •    Cost-effective bearings to ensure acceptable vibration levels at all speeds

                •    A balancing scheme that allows fast and efficient balancing of the rotor and shaft

                •    A touchdown bearing system to stabilize the rotor during abnormal conditions such as an earthquake.

    Ramping up and maintaining production rates.

        There can be no assurance that we will be successful in meeting these challenges. In addition, even if we are able to complete development of the new Smart Energy 25 flywheel system, we plan to integrate multiple Smart Energy 25 flywheels into a common facility to produce the Smart Energy Matrix™. This effort will pose significant technological and cost challenges such as:

    Designing the control system and interface of the separate flywheels so that they act as an integrated matrix

    Meeting the technical requirements for interconnection to the utility grid

    Developing a communication system adequate to meet the performance standards of grid managers.

Although the market for frequency regulation services is large and growing, we have not demonstrated an ability to sell into that market.

        We intend to provide frequency regulation services using our Smart Energy Matrix™ in the open-bid auction markets of regional grid operators, such as PJM Interconnection. In order to bid in these markets, one must be qualified to do so. Although our technology has been qualified in three of the five ISOs that we are targeting, and we expect to receive the necessary approvals in the remaining markets, there is no assurance we will be successful.

        In addition, if regulatory modifications change the structure of the markets, such modifications could adversely affect our business plan. Also, for us to be successful in most of these markets there must be market rule changes made to allow non-generator companies such as ours to compete with current market participants. If the auction market rules change in the future or current modifications being developed as a result of FERC Rule 890 are not implemented, we may be required to change our business plan and there can be no assurance that we will be successful in doing so.

Although the Federal Energy Regulatory Commission has mandated that ISOs allow non-generation resources (such as ours) to provide regulation services, each of several ISOs must modify their separate market rules for us to be able to sell our frequency regulation services in each such market.

        On February 16, 2007 the Federal Energy Regulatory Commission issued Order 890 which, among other things, directed each ISO/RTO to amend its tariff to allow non-generation resources (such as ours) to bid into its frequency regulation market. Currently only PJM is in full compliance with Order 890, with market tariffs in place that will allow us to participate in their markets. NYISO, ISONE, MISO and CAISO still must modify their market rules to allow us to participate and earn revenue in these markets.

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        We are actively engaged both at the FERC and with each ISO on the development of new market rules that would allow our participation. However, the timing of when market rules for each ISO/RTO will be amended to allow our participation is uncertain. There can be no assurance that the amendments to the various tariff structure will occur in a timeframe that will allow us to achieve our business plan or that the revised tariff structure for a particular ISO will result in a market for that ISO that we can participate in on a profitable basis.

Although the NYISO has stated that we are able to participate in its market as a non-generator resource, its payment rules may pose financial risks for us that will make participation in that market unlikely.

        Our technology is fundamentally different than a traditional generator. First and foremost, generators are assumed to be able to provide energy for an unlimited period of time, whereas we can only provide energy to the grid for a limited period of time. In NYISO, generators providing regulation service are also required to bid into the energy market. In order to avoid being called on to provide energy, we must bid in a high energy price. This strategy poses financial risks to us in two ways. First, during times of high energy prices, if we do not bid a high enough energy price, we may become committed to provide more energy than we have stored, and then may have to procure such extra energy on the market, so as to be able to meet our commitment. Second, if we do bid a high enough energy price to insure that we are not selected to provide energy, the NYISO may view our overall bids less favorably, which could limit the number of hours we are selected by NYISO to provide regulation.

        There can be no assurance that the rules in NYISO will be modified in a timeframe that will allow us to achieve our business plan or that the rules will allow us to have sufficient success in the NYISO bid-market to operate on a profitable basis.

Reductions in energy prices may have a material impact on the pricing of frequency regulation services and therefore the profitability of our flywheel systems.

        The market pricing for frequency regulation services tends to follow the pricing for energy, hence if the price of energy drops, frequency regulation prices could be adversely affected.

Our ability to complete commercialization of our Smart Energy Matrix™ will require substantial funds. Our stockholders may be adversely affected if we issue debt securities or additional equity securities to obtain financing.

        We will require substantial funds to complete research and development activities, market our products and services, deploy our systems, and increase our revenues. We anticipate that such funds will be obtained from external sources and intend to seek additional equity or debt to fund future operations. Although approximately $42.6 million was raised in 2007, we estimate that we will need to raise an additional $20 million during 2008 through the issuance of equity securities in order to complete development of the Smart Energy Matrix™ flywheel system, and to build, operate and receive fees for frequency regulation services and yet have sufficient working capital to continue to execute our business plan. Our business plan includes manufacturing the flywheel systems and building the facilities for a multiple megawatt site in New York and a one to five megawatt facility at either NE ISO or PJM. Beyond 2008 we will continue to have capital needs that will require additional equity or debt, for example, to fund the complete build-out of the NY facility to 20 megawatts.

        Our actual capital requirements will depend on many factors. The additional funding we require may not be available on favorable terms, if at all. Such additional funding may only be available on terms that may, for example, cause substantial dilution to common stockholders, and/or have liquidation preferences and/or pre-emptive rights. If we raise additional funds by issuing debt securities or additional equity securities, existing stockholders may be adversely affected because new investors may have rights superior to current stockholders and current stockholders may be diluted.

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        If we do not succeed in raising additional funds, we will be unable to complete planned development of our products and services. In addition, we could be forced to take unattractive steps, such as slowing or discontinuing product development, slowing our cost reduction program, limiting the services offered, reducing or foregoing sales and marketing efforts and attractive business opportunities, or discontinuing operations entirely.

        We expect that it will be several years before we will recognize significant revenues from the products we intend to offer and the services we intend to provide. A large portion of our expenses are fixed, including expenses related to facilities, equipment and key personnel. In addition, we expect to spend significant amounts to fund product development based on our core technologies. We also expect to incur substantial expenses to manufacture our Smart Energy Matrix™ product in the future. As a result, operating expenses may increase significantly over the next several years and, consequently, we will need to generate substantial commercial revenue to achieve profitability. Even if we do achieve profitability, we may not be able to sustain or increase profitability on a consistent basis.

We intend to bring our frequency regulation services to market through participation in the energy open-bid auction markets, where on a national basis the amount of frequency regulation required is typically one percent of all power produced. If changes in this percentage occur due to regulatory modifications and are not offset by a proportionate increase in pricing for frequency regulation, our business plan could be adversely affected.

        The regulatory landscape is in constant flux, and we are aware that a North American Electric Reliability Council (NERC) subcommittee is in the process of developing a new NERC standard that may reduce the amount of frequency regulation required by lowering the ratio of frequency regulation to power generated. There is not yet a consensus on the potential changes to the standard. The new NERC standard may not be adopted as currently proposed, and even if adopted, regional grid operators have the unilateral option under FERC rules to adhere to regional frequency regulation standards that are not less rigorous, and may in fact be more rigorous, than the proposed new standard. Even if a new standard is passed, the belief by such ISOs and other powerful utility stakeholders that such changes could create possible negative impacts on overall grid reliability make it likely that more rigorous standards will continue to be the rule in at least some areas, including California and New England. However, if adopted, the proposed changes potentially could be harmful to us by: a) reducing the amount of frequency regulation required by Independent System Operators in such a way as to reduce the total size of the US frequency regulation market, b) lowering the price of frequency regulation as a consequence of any potential lower demand that might result from a change in regulatory standards, and c) increasing our cost of providing the service. Any combination of these things could adversely impact our ability to access the markets for frequency regulation or to do so in a profitable or sustainable basis.

        There are market-expanding developments that may partially counterbalance some or all of the above possible changes in the NERC standard. For example, efforts by some states to increase the amount of renewable energy that is produced for the grid from wind and solar power may expand the market for frequency regulation services. From our conversations with grid operators, we believe that the variable changes in energy output caused by natural and constant changes in wind speed and cloud cover will require increased frequency regulation to balance this variability. However, there can be no assurance that these anticipated expansions will occur in a timeframe that will allow us to achieve our business plan or participate in the expanded market on a profitable basis.

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Our revenue and sales depend upon the achievement of the product development and commercialization milestones set forth in our contracts with third parties. Our future revenues will result from similar milestones related to government contracts and from our commercial applications. These revenues will depend on our ability to deliver flywheel systems with certain performance and dependability attributes.

        The majority of our revenue is currently derived from contracts with governmental entities in which payments to us are based primarily on achieving certain product development and commercialization milestones as set forth in those contracts. We expect that our future revenue from government sources will similarly be milestone-driven and not of sufficient volume to be a profitable business.

        On commercial applications for our flywheel systems, our ability to achieve revenues will be dependent on our ability to complete development of our systems, expand our manufacturing capabilities, achieve cost reduction goals, obtain sufficient funds to deploy these systems and participate profitably within the market rules of the open-bid auction markets mentioned above. It is uncertain whether and to what degree we will be able to meet these goals in the future. To the extent we do not meet such goals we expect our revenue to be negatively affected.

Our business plan includes the design, development, construction, financing and operation of several frequency regulation power facilities that incorporate our Smart Energy Matrix™ technology in order to provide frequency regulation services. We have no prior experience doing this. Should we fail in any material aspect of these tasks, it is unlikely that we will recognize significant revenue under our current business model.

        Our business plan calls for the design, development, construction, financing and operation of one or more commercial-level frequency regulation power plants that incorporate our Smart Energy Matrix™ technology. However, we have no experience with such projects at a commercial level, although we have designed, developed, constructed and installed two one-tenth scale demonstration units at existing utility sites on the grid and have operated or are now operating them in demonstration and testing mode. However, we have never done these things commercially, nor ever obtained project financing (although we have experience in equity transactions). We expect that executing these tasks on a commercial level will be complex and challenging and we may not be successful. If we are not successful, then we will not achieve the revenues planned in our business model.

We have a history of losses and anticipate future losses and we will have limited revenues in the near term. Unless we raise additional capital to operate our business, we may not be able to continue as a going concern. Even with the cash raised in 2007, our cash balances are sufficient to fund operations only into approximately the fourth quarter of 2008.

        We have incurred significant losses from operations since our inception. As shown in our consolidated financial statements, we incurred significant losses from operations of approximately $13,620,000, $12,682,000 and $9,448,000 and operating cash decreases of approximately $11,282,000, $8,441,000 and $8,923,000 during the years ended December 31, 2007, 2006 and 2005, respectively. We expect to have positive EBITDA and be cash flow positive by 2010; however, to be successful we will need to raise additional capital in 2008 and 2009. In the event that we are not successful in raising equity or the timing of bringing in additional cash is delayed, we may not be successful.

        We had approximately $30.4 million in cash and cash equivalents on hand at December 31, 2007. Based on our current cash usage rates and additional expenditures expected in support of our business plan, we estimate that we have adequate cash to fund operations only into the fourth quarter of 2008.

        We are focused on further development of the Smart Energy Matrix™ to provide frequency regulation services, but this product will not generate significant revenues in the near term. We expect future revenues to come primarily from the sale of services related to the Smart Energy Matrix™ and from possible sales of Smart Energy 25 flywheel units in the future. Other than revenue related to our

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research and development contracts in the amount of $3.4 million, we have had no revenues to date from our Smart Energy Matrix™. The timing of future revenues is uncertain.

        Miller Wachman, LLP, our independent auditors, have included an explanatory paragraph related to a going concern uncertainty in their audit report on our consolidated financial statements for the fiscal year ended December 31, 2007, which identifies our recurring losses and negative cash flows and raises substantial doubt about our ability to continue as a going concern.

        Our financial statements have been prepared on the basis of a going concern, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. We have not made any adjustments to our financial statements as a result of the going concern uncertainty. If we cannot continue as a going concern, we may have to liquidate our assets and may receive significantly less than the values at which they are carried on our financial statements. Any shortfall in the proceeds from the liquidation of our assets would directly reduce the amounts that holders of our common stock could receive in liquidation.

Increases or decreases in purchase prices or availability of carbon fiber or other materials and commodities may affect our ability to achieve profitability.

        We use carbon fiber in the manufacture of our flywheel systems. Other applications that require carbon fiber have substantially increased in the last few years. In response to this increased demand, suppliers are adding capacity but shortages and/or price fluctuations may affect our ability to manufacture our flywheel systems in a timely way and at a reasonable cost.

Our competitive position could be impaired if we either fail to protect our intellectual property or infringe third-party patent rights.

        We cannot provide assurance that we have or will be able to maintain a significant proprietary position on the basic technologies used in our flywheel systems. Our ability to compete effectively against alternative technologies will be affected by our ability to protect proprietary technology, systems designs and manufacturing processes. We do not know whether any of our pending or future patent applications under which we have rights will issue, or, in the case of patents issued or to be issued, that the claims allowed are or will be sufficiently broad to protect our technology or processes from competitors. Even if all of our patent applications are issued and are sufficiently broad, they may be challenged or invalidated. We could incur substantial costs in prosecuting or defending patent infringement suits, and such suits would divert funds and resources that could be used in our business. We do not know whether we have been or will be completely successful in safeguarding and maintaining our proprietary rights.

        Further, our competitors or others may independently develop or patent technologies or processes that are substantially equivalent or superior to ours. If we are found to be infringing on third-party patents, we do not know whether we will be able to obtain licenses to use such patents on acceptable terms, if at all. Failure to obtain needed licenses could delay or prevent the development, manufacture or sale of our systems. See Item 3, "Legal Proceedings", regarding litigation commenced against the Company by a third party, alleging patent infringement.

        We rely, in part, on contractual provisions to protect trade secrets and proprietary knowledge. These agreements may be breached, and we may not have adequate remedies for any breach. Our trade secrets may also be known without breach of such agreements or may be independently developed by competitors or others. Our inability to maintain the proprietary nature of our technology and processes could allow competitors or others to limit or eliminate any competitive advantages we may have.

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Government regulation may impair our ability to market our products.

        Government regulation of our products, whether at the federal, state or local level, including any change in regulations or tariffs, product buy downs or tax rebates relating to purchase and installation of our products, may increase the cost and price of our systems, and may have a negative impact on our revenue and profitability. We cannot provide assurance that our products will not be subject to existing or future federal and state regulations governing traditional electric utilities and other regulated entities. We expect that our products and their installation will be subject to oversight and regulation at the local level in accordance with state and local ordinances relating to building codes, safety and related matters. We do not know the extent to which any existing or new regulations may impact our ability to distribute, install and service our products. Once our products reach the commercialization stage, federal, state or local government entities may seek to impose regulations.

The exercise of options and warrants and other issuances of shares will likely have a dilutive effect on our stock price.

        As of December 31, 2007, there were outstanding options to purchase an aggregate of 8,712,488 shares of our common stock at prices ranging from $0.255 per share to $9.31 per share, of which options to purchase 6,766,700 shares were exercisable as of such date. As of December 31, 2007, there were outstanding warrants to purchase 28,891,377 shares of our common stock, of which 11,299,607 were exercisable as of December 31, 2007.

        The exercise of options and warrants at prices below the market price of our common stock could adversely affect the price of our common stock. Additional dilution may result from the issuance of shares of our capital stock in connection with collaborations or manufacturing arrangements or in connection with other financing efforts.

Our financial performance could be adversely affected if we are unable to retain or attract key technical personnel.

        Our future success also depends to a large degree on the technical skills of our engineering staff and our ability to attract key technical personnel. Competition for skilled technical professionals is intense and we may not be successful in attracting and retaining the talent necessary to design, develop and manufacture our flywheel products.

Competitors in the frequency regulation market include established utilities and independent service providers with far greater resources than we have.

        The frequency regulation services market is being served by well-known utilities and independent service providers that use conventional generators. We will be competing with established generators that have far greater resources than we do.

We have anti-takeover defenses that could delay or prevent an acquisition and changes in control that could adversely affect the price of our common stock.

        Provisions of our certificate of incorporation, by-laws, Rights Agreement and Delaware law may have the effect of deterring unsolicited takeovers or delaying or preventing changes in control of management, including transactions in which our stockholders might otherwise receive a premium for their shares over then current market prices. In addition, these provisions may limit the ability of stockholders to approve transactions that they may deem to be in their best interest.

        Our certificate of incorporation permits our board of directors to issue preferred stock without stockholder approval upon such terms as the board of directors may determine. The rights of the holders of our common stock will be subject to, and may be adversely affected by, the rights of the

20



holders of any preferred stock that may be issued in the future. The issuance of preferred stock, while providing desirable flexibility in connection with possible acquisitions and other corporate purposes, could have the effect of making it more difficult for a third party to acquire, or of discouraging a third party from acquiring, a majority of our outstanding common stock. Although we have no present intention of issuing any additional preferred stock, an issuance of a substantial number of preferred shares could adversely affect the price of our common stock.

        In addition, our certificate of incorporation and our by-laws provide that:

    Our directors may only be removed for cause by a majority of the outstanding capital stock entitled to vote in the election of directors

    Our stockholders do not have the power to call special meetings of stockholders; and

    The provisions relating to the removal of directors and calling of special stockholders meetings may only be amended by a 662/3% vote of the outstanding shares of common stock, voting together as a single class.

        These provisions make it more difficult for our stockholders to change the composition of the board of directors and approve transactions they may deem to be in their best interests that are not approved by the board of directors.

        Pursuant to a Rights Agreement, we issued rights as a dividend on common stock on October 7, 2002, each of which entitles the holder to purchase 1/100th of a share of newly issued preferred stock for $22.50 in the event that any person not approved by the board of directors acquires more than 15% of our outstanding common stock, or in the event of an acquisition by another company, $22.50 worth of the common stock of the other company at half its market value (in each case the rights held by the acquiring person are not exercisable and become void). On October 24, 2007, we entered into Amendment No. 3 (the "Amendment") to the Rights Agreement, dated as of September 25, 2002, between the Company and Computershare Trust Company, N.A. (fka Equiserve Trust Company, N.A.), as Rights Agent, as previously amended by Amendment No. 1 dated as of December 27, 2002 and Amendment No. 2 dated as of August 8, 2007 (as amended, the "Rights Agreement"). The Amendment allows The Quercus Trust and persons who are beneficial owners through it to have a beneficial ownership percentage of up to 20% of the Company's Common Stock without triggering the rights under the Rights Agreement. The Amendment also excludes from the beneficial ownership computations used to determine whether a person has become an Acquiring Person (as defined in the Rights Agreement) those securities that might otherwise be acquired by exercising a warrant but for a limitation in such warrant or elsewhere that prevents such exercise to the extent it would cause such person to become an Acquiring Person.

Item 1B.    Unresolved Staff Comments

        None

Item 2.    Properties

        In January 2008, we relocated our principal executive offices, laboratory and manufacturing facilities from Wilmington, Massachusetts to our new corporate headquarters located at 65 Middlesex Road, Tyngsboro, MA. This 103,000 square foot facility, which has been renovated to meet our needs, operates under a lease that expires in September 2014, with options to renew for two additional seven-year periods. Our new facility significantly expands our manufacturing capacity and provides us with sufficient space to continue our research and development activities. Our new facility has a potential manufacturing capacity for the production of more than 1,000 flywheels per year, although based on the manufacturing build-out that we have completed the facility has a capacity for the production of 600 flywheels per year. We have purchased an option to buy land in Stephentown, NY in

21



anticipation of building our first 20 megawatt frequency regulation facility on that site, upon approval of the NY interconnection application filed in late 2007. In addition, we are evaluating several other possible locations for future service providing facilities.

Item 3.    Legal Proceedings

        On October 9, 2007, Arete Power, Inc. filed a complaint against the Company, claiming damages from alleged willful infringement of U.S. Patent No. 6,710,489, entitled "Axially Free Flywheel System." On November 30, 2007, Beacon filed an Answer denying infringement and a Counterclaim seeking a declaratory judgment that the '489 patent is invalid. At the same time, Beacon filed a motion to transfer the lawsuit from the Northern District of California to the District of Massachusetts. On February 22, 2008, the Court granted Beacon's motion to transfer the lawsuit to the District of Massachusetts. We believe that this lawsuit is without merit and we plan to vigorously defend the Company against the lawsuit.

Item 4.    Submission of Matters to a Vote of Security Holders

        None

PART II

Item 5.    Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

        Our common stock is quoted on the NASDAQ Capital Market under the symbol "BCON". The following table sets forth the high and low sales price of the common stock for the periods indicated.

 
  High
  Low
Year ended December 31, 2007            
  Fourth quarter   $ 2.32   $ 1.42
  Third quarter   $ 2.29   $ 1.35
  Second quarter   $ 1.26   $ 0.77
  First quarter   $ 1.21   $ 0.76

Year ended December 31, 2006

 

 

 

 

 

 
  Fourth quarter   $ 1.24   $ 0.99
  Third quarter   $ 1.54   $ 1.12
  Second quarter   $ 1.82   $ 1.02
  First quarter   $ 2.15   $ 1.42

        On March 7, 2008 the last reported sale price of our common stock on the NASDAQ Capital Market was $1.08 per share, and there were 291 holders of record of common stock. The number of record holders does not include holders of shares in "street name" through brokers.

        We have never declared or paid cash dividends on shares of our common stock. We expect to retain any future earnings, if any, to finance the expansion of our business, and therefore do not expect to pay cash dividends in the foreseeable future. Payment of future cash dividends, if any, will be at the discretion of our board of directors after taking into account various factors, including our financial condition, operating results, current and anticipated cash needs and plans for expansion.

Purchases of Equity Securities by the Issuer and Affiliated Purchasers

        There was no stock repurchase activity in 2007.

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Item 6.    Selected Consolidated Financial Data

        The following selected financial data should be read together with "Management's Discussion and Analysis of Financial Condition and Results of Operations" and the financial statements, including the related notes, found elsewhere in this Form 10-K. The tables that follow present selected historical financial data for the years ended December 31, 2007, 2006, 2005, 2004 and 2003 and for the period from May 8, 1997, the date of Beacon's inception, through December 31, 2007.

 
   
   
   
   
   
  Period from
Date of Inception
May 8, 1997
through December 31,
2007

 
 
  Year ended December 31,
 
 
  2007
  2006
  2005
  2004
  2003
 
 
  (in thousands, except per share data)

 
Consolidated Statements of Operations Data:                                      
Revenue   $ 1,389   $ 969   $ 1,487   $ 325   $   $ 4,721  
Cost of goods sold     1,248     845     1,575     1,458         5,126  
   
 
 
 
 
 
 
Gross profit     141     124     (88 )   (1,133 )       (405 )
Operating expenses:                                      
  Selling, general and administrative     5,876     6,508     6,334     4,197     4,936     50,975  
  Research and development     8,387     4,748     1,408     3,532     3,550     68,418  
  Loss on contract commitments     (578 )   1,385     1,535             2,717  
  Depreciation and amortization     145     96     83     187     285     4,462  
  Casualty loss (recovery)     (69 )   69                  
  Restructuring charges                         2,159  
  Loss on impairment of assets                     367     4,664  
   
 
 
 
 
 
 
    Total operating expenses     13,761     12,806     9,360     7,916     9,138     133,395  
   
 
 
 
 
 
 
Loss from operations     (13,620 )   (12,682 )   (9,448 )   (9,049 )   (9,138 )   (133,800 )
Interest and other income (expense), net     702     519     136     3,719     520     7,480  
   
 
 
 
 
 
 
Net loss     (12,918 )   (12,163 )   (9,312 )   (5,330 )   (8,618 )   (126,320 )
Preferred stock dividends                         (36,826 )
Accretion of redeemable convertible preferred stock                         (113 )
   
 
 
 
 
 
 
Loss to common shareholders   $ (12,918 ) $ (12,163 ) $ (9,312 ) $ (5,330 ) $ (8,618 ) $ (163,259 )
   
 
 
 
 
 
 
Loss per share, basic and diluted   $ (0.18 ) $ (0.21 ) $ (0.20 ) $ (0.12 ) $ (0.20 )      
   
 
 
 
 
       
Shares used in computing net loss per shares, basic and diluted     73,604     59,080     47,666     43,453     42,886        
   
 
 
 
 
       

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  As of December 31,
 
  2007
  2006
  2005
  2004
  2003
 
  (in thousands)

Balance Sheet Data:                              
Cash and cash equivalents   $ 30,417   $ 5,251   $ 13,890   $ 5,097   $ 8,909
Working capital     28,820     3,310     13,223     4,213     8,838
Total assets     39,778     7,258     16,126     7,086     12,067
Total stockholders' equity (deficiency)     36,198     3,900     13,655     5,110     9,692

Item 7.    Management's Discussion and Analysis of Financial Condition and Results of Operation

        The following discussion of our financial condition and results of operations should be read in conjunction with our financial statements, the notes to those financial statements and other financial information appearing elsewhere in this document. In addition to historical information, the following discussion and other parts of this document contain forward-looking statements that reflect plans, estimates, intentions, expectations and beliefs. Actual results could differ materially from those discussed in the forward-looking statements. See "Note Regarding Forward-Looking Statements." Factors that could cause or contribute to such differences include, but are not limited to, those set forth in the "Risk Factors" in Item 1A and contained elsewhere in this Form 10-K.

Critical accounting policies and estimates

        The preparation of financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues, expenses and related disclosures. On an ongoing basis, management evaluates our estimates and assumptions including, but not limited to, those related to revenue recognition, asset impairments, inventory valuation, warranty reserves and other assets and liabilities. Management bases its estimates on historical experience and various other assumptions that it believes to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

Revenue Recognition

        Although we have shipped products and recorded contract revenues, our operations have not yet reached a level that would qualify us to emerge from the development stage. Therefore we continue to be accounted for as a development stage company under Statement of Financial Accounting Standards No. 7, "Accounting and Reporting by Development Stage Enterprises."

Product Sales

        We recognize revenues in accordance with accounting principles generally accepted in the United States of America. Generally, revenue is recognized on transfer of title, typically when products are shipped and all related costs are estimable. For sales to distributors, we make an adjustment to defer revenue until products are subsequently sold by distributors to their customers.

Government Contract Revenue Recognized on the Percentage-of-Completion Method

        We recognize contract revenues using the percentage-of-completion method, based primarily on contract costs incurred to date compared with total estimated contract costs. Changes to total estimated contract costs or losses, if any, are recognized in the period in which they are determined. Revenues recognized in excess of amounts billed are classified as current assets, and included in "Prepaid expenses and other current assets" in our balance sheets. Amounts billed to clients in excess of

24



revenues recognized to date are classified as current liabilities under "Advance billings on contracts." Changes in project performance and conditions, estimated profitability, and final contract settlements may result in future revisions to construction contract costs and revenue.

        All of our research and development contracts are subject to cost review by the respective agencies. Our reported results from these contracts could change adversely as a result of these reviews.

Loss on Contract Commitments

        Each quarter, we perform an evaluation of expected costs to complete our in-progress contracts that we account for using the percentage-of-completion method. In the event that the total expected costs to complete a contract exceed the expected total contract revenue, we immediately record a loss on the contract to the extent that the expected loss exceeds the expected revenue from the contract.

Inventory Valuation

        We value our inventory at the lower of actual cost or the current estimated market value. We regularly review inventory quantities on hand and record a provision for excess and obsolete inventory. For the years ended December 31, 2007, 2006 and 2005, reserves were recorded to fully offset the value of our inventory. These impairment charges were made due to the uncertainty of realizing any future value from the inventory due to the lack of substantial revenues to date from our inverter product line. Materials used in the development of the Smart Energy 25 flywheel and our other development efforts are considered research and development materials, and are expensed as incurred in accordance with Statement of Financial Accounting Standards No. 2, "Accounting for Research and Development Costs." Materials purchased for the production of flywheels are expected to be capitalized as part of our planned frequency regulation facilities and have been classified as "Construction in Progress" and are included in Property and equipment on our balance sheet.

Patent Costs

        We capitalize external legal costs incurred in the defense of our patents where we believe that the future economic benefit of the patent will be increased. We monitor the legal costs incurred and the anticipated outcome of the legal action and, if changes in the anticipated outcome occur, capitalized costs will be adjusted in the period the change is determined. Patent costs are amortized over the remaining life of the patents. We own intellectual property in the form of patents on our flywheel vacuum system, our heat pipe cooling systems, DC output paralleling, metal hub, low-loss motor, co-mingled rims and earthquake-tolerant bearings on our flywheel products, and anti-islanding software, drawings, source code, and production know-how on our inverter products, and expect to obtain other patents during 2008 and beyond. In December 2004, we recorded impairment charges to write down our capitalized patent costs to zero due to the lack of substantial revenues to date and the uncertainty of realizing any future value from these patents, Accordingly, all costs incurred during 2007, 2006 and 2005 related to the development of intellectual property have been expensed as incurred.

Warranty Reserves

        The solar inverters we have sold carry warranties that require us to repair or replace defective products returned to us during the applicable warranty period at no cost to the customer. We record an estimate for warranty-related costs based on actual historical return rates, anticipated return rates and repair costs at the time of sale.

Income Taxes

        Deferred tax assets and liabilities are determined based on differences between the financial reporting and income tax bases of assets and liabilities, as well as net operating loss and tax credit

25



carry-forwards, and are measured using the enacted tax rates and laws that will be in effect when the differences reverse. Deferred tax assets are reduced by a valuation allowance to reflect the uncertainty associated with their ultimate realization.

        Significant management judgment is required in determining the provision for income taxes, the deferred tax assets and liabilities and any valuation allowance recorded against deferred tax assets. The valuation allowance is based on our estimates of taxable income and the period over which our deferred tax assets will be recoverable. In the event that actual results differ from these estimates or we adjust these estimates in future periods, we may need to establish an additional valuation allowance or reduce our current valuation allowance which could materially impact our tax provision. We classify interest and penalties relating to uncertain tax positions in income tax expense.

Fixed Assets

        Fixed assets are defined as tangible items with unit costs exceeding our capitalization threshold that are used in the operation of the business, are not intended for resale and which have a useful life of one year or more. The cost of fixed assets is defined as the purchase price of the item, as well as all of the costs necessary to bring it to the condition and location necessary for its intended use. Repair and maintenance costs are expensed as incurred. Capital assets are classified as "Construction in Progress" (CIP) when initially acquired, and reclassified to the appropriate asset account when placed into service. Depreciation expense is not recorded on assets not yet placed into service. Materials purchased to build flywheels for use in company-owned frequency regulation facilities are classified as CIP, along with the related labor and overhead costs. No overhead is generally applied for other internally-constructed projects not directly related to our core business (e.g., leasehold improvements.)

Impairment of Long-Lived Assets

        In accordance with Statement of Financial Accounting Standards No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets" long-lived assets are reviewed to determine whether any events or changes in circumstances indicate that the carrying value of the asset may not be recoverable. The conditions to be considered include whether or not the asset is in service, has become obsolete, is damaged, or whether external market circumstances indicate that the carrying amount may not be recoverable. When appropriate, we recognize a loss for the difference between the estimated fair value of the asset and the carrying amount. The fair value of the asset is measured using either available market prices or estimated discounted cash flows. Our analyses indicate that there was an impairment of certain long-lived assets as a result of the December prototype malfunction, and we recognized an asset impairment charge of approximately $18,000 in 2006. This represented the estimated cost to repair certain damaged items. Based on our annual analysis, no asset impairment charges were considered necessary for 2007. In 2002, we incurred a restructuring and impairment charge of $6.5 million of which $4.3 million represented impaired capital equipment and leasehold improvements. Many of the assets for which a reserve had previously been recorded were disposed of during the move to the Tyngsboro facility, and therefore the assets and the related accumulated depreciation and reserves were written off as of the end of fiscal 2007.

Overview

        Our initial product strategy was to develop high energy, composite flywheels for back-up powering of telecommunications applications. Our product was in low-rate initial production when the collapse of the telecommunications market began in 2001. We recognized that our Smart Energy flywheel products as alternative backup solutions to the telecommunications industry were not a means to produce meaningful revenues. With that recognition, we initiated a series of cost cutting measures throughout 2002 and 2003. The focus of these efforts were to reduce cash usage while preserving our intellectual properties and maintaining the integrity of our public company requirements while evaluating all

26



potential product markets for our technologies and considering acquisitions or mergers that could lead to increased shareholder value. We have:

    (i)
    Identified promising applications for our Smart Energy Matrix™ design in the electric utility power grid marketplace.

    (ii)
    Pursued additional development and design contracts for a variety of applications by federal agencies. We have been successful in obtaining contracts and are continuing our efforts to obtain additional research and development funding.

    (iii)
    Field-tested scale-model Smart Energy Matrix flywheel systems for frequency regulation in two states, which has resulted in certification or acceptance of our technology for frequency regulation in three ISOs, as discussed elsewhere in this document.

    (iv)
    Completed a significant portion of the development effort for our Smart Energy 25 flywheel.

        We must raise additional funds to execute our business plan. Although funding of approximately $42.6 million was raised in 2007, based on our rate of expenditure of cash and the additional expenditures expected to support our business plan, we estimate that we have sufficient cash to fund operations into approximately the fourth quarter of 2008. We need to obtain additional investments in 2008 to fund:

    Our continuation as a going concern

    Ongoing research and development of the Smart Energy 25 flywheel and the Smart Energy Matrix™ multi-flywheel system

    Continuing the ramp-up of our manufacturing and assembly capacity

    The design and build-out of facilities to provide frequency regulation services to the electricity grid

    Working capital requirements; and

    The identification and development of new business opportunities.

        In order to complete development of the Smart Energy Matrix™ flywheel system, build, operate and receive fees for frequency regulation services of at least one megawatt from a commercial sized flywheel-based frequency regulation system and have sufficient working capital to continue to execute our business plan through 2008, we will need to raise approximately $20 million of funding. Also, we will need to raise additional amounts through equity and debt beyond the foregoing $20 million to finance the additional frequency regulation facilities that are contemplated by our business plan.

        As part of our new business development, we may evaluate possible acquisitions of enterprises or technologies that we would consider synergistic from a market, technology or product perspective.

        From inception through December 31, 2007, we have incurred losses of approximately $163 million. We expect to continue to incur losses as we expand our product development and begin to increase our manufacturing capacity.

Revenues

        We were awarded fixed price research and development contracts from government agencies and are pursuing similar contracts from other government agencies. We have determined that we will recognize revenues using the percentage of completion method for such contracts. We are continuing to evaluate markets for our flywheel systems but we have not recognized revenues from these products. We have placed development prototype flywheels with potential customers and shipped pre-production units. These flywheel products were provided to potential customers without charge or on a

27



demonstration basis to allow us access to field test information and to demonstrate the application of our technologies.

Cost of Goods Sold

        Cost of goods sold on fixed price research and development contracts are predominantly being recorded on the percentage of completion method and consist primarily of direct labor and material, subcontracting and associated overhead costs.

Selling, General and Administrative Expenses

        Our sales and marketing expenses consist primarily of compensation and benefits for sales and marketing personnel and related business development expenses. We expect sales and marketing expenses to continue to increase as we expand efforts to define new markets for our products. General and administrative expenses consist primarily of compensation and benefits related to our corporate staff, professional fees, insurance and travel. In 2006, our selling, general and administrative expenses increased, primarily due to compensation costs associated with equity based compensation. Our selling, general and administrative expenses for 2007 are approximately 10% lower than during the same period during 2006, due primarily to a reduction in public company expenses, reduced use of subcontractors and consultants, lower stock compensation expense as a result of fewer new hire option grants and a lower Black Scholes fair value for options issued during the early portions of the fiscal year and allocation of a portion of our general and administrative expenses to our Government contracts. These reductions in cost were partially offset by slight increases in salaries and benefits resulting from new hires. We expect our selling, general and administrative expenses to increase in 2008 over 2007 due primarily to additional staffing to support expanding our marketing efforts for Government sales and Government backed loans for new facilities as well as increased regulatory efforts to modify market rules to insure our ability to compete in these markets.

Research and Development

        Our cost of research and development consists primarily of the cost of compensation and benefits for research and development staff, as well as materials and supplies used in the engineering design and development process. In 2005, we began development efforts on our Smart Energy 25 flywheel system, and research and development costs have increased considerably from 2005 to 2006, and again from 2006 to 2007. Our research and development costs during 2007 were approximately 77% higher than during the same period in 2006, due to higher engineering salary and benefit costs related to headcount increases late in 2006 to support development and testing, higher facility costs and moving expenses, increased use of consultants and contractors, as well as more expense material used to develop and test our Smart Energy 25 flywheel system. We expect research and development expenses to increase during 2008 as we finalize our designs and focus on our cost reduction objectives.

Loss on Contract Commitments

        We will establish reserves for anticipated losses on contract commitments if, based on cost estimates to complete the commitment, we determine that a loss will be incurred. We recorded a $1.4 million charge during 2006 and $1.5 million in 2005 for anticipated losses on our research and development contracts. In 2007, we completed all but one of our existing contracts. These contracts were completed at costs that were lower than previously anticipated, and we recorded a reduction of approximately $0.6 million to the contract loss reserve. We are most likely to recognize probable losses on contract commitments early in a product's introduction prior to being able to realize expected decreases in cost per unit through engineering design changes, operating efficiencies, and volume purchasing discounts. On government contracts, we will, on a quarterly basis, evaluate our estimated costs to complete and establish reserves when appropriate.

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Restructuring and asset impairment charges

        We did not recognize any material restructuring charges in 2007, 2006 or 2005. Asset impairment charges of approximately $18,000 were recorded in 2006 related to damages resulting from a prototype malfunction in December 2006.

Depreciation and Amortization

        Our depreciation and amortization is primarily related to depreciation on capital expenditures and the amortization of lease and leasehold costs related to our facilities. We have intellectual property in the form of patents on our flywheel vacuum system, heat pipe cooling systems, DC output paralleling, metal hub, low-loss motor, co-mingled rims and earthquake-tolerant bearings on our flywheel products, anti-islanding software, drawings, source code and production know-how on our Smart Power M5 inverter system, and expect to obtain other patents during 2008 and beyond. These costs were being amortized during 2004, but we recorded impairment charges to write down these assets to zero on the balance sheet at December 31, 2004. These impairment charges were made due to the uncertainty of realizing any future value from this property mainly due the lack of substantial revenues to date. Accordingly, all costs incurred during 2007, 2006 and 2005 related to the development of intellectual property were expensed as incurred.

Interest and Other Income/Expense, net

        In 2007 and 2006, non-operating income consisted primarily of interest income resulting from cash on hand. Approximately $10,000 and $18,000 were received in 2007 and 2006, respectively, in settlement of a class action suit relating to unfair practices engaged in by certain insurance brokerage firms, and a gain related to the sale of a fixed asset of approximately $3,000 was recognized in 2007. In 2005, our non-operating income and expenses were primarily attributable to realized gains on the sale of our available-for-sale securities and a warrant, a write-back resulting from loan payments on a reserved loan to a former officer of the Company, a cash settlement relating to our failed attempt to acquire NxtPhase T&D Corporation, interest income resulting from cash on hand, accrued dividends receivable and the 7% conversion premium from the conversion of our holdings of Series A Preferred Stock of Evergreen Solar, Inc., partially offset by interest expense associated with our capital leases.

Accounting Pronouncements

Recently Adopted Accounting Pronouncements

        During the first quarter of 2006, we adopted the provisions of, and accounted for, stock-based compensation in accordance with the Financial Accounting Standards Board's Statement of Financial Accounting Standards No. 123R ("SFAS 123R"), "Share-Based Payment." In conjunction with the adoption of SFAS 123R, we also adopted SEC Staff Accounting Bulletin 107 ("SAB 107"), which provides additional guidance on disclosure topics related to share-based payments.

        Under the fair value recognition requirement of SFAS 123R, stock-based compensation cost is measured at the grant date based on the fair value of the award and is recognized as an expense as it is earned over the requisite service period, which is the vesting period. To implement this standard, we elected the modified-prospective transition method, under which prior periods are not revised for comparative purposes. The valuation provisions of SFAS 123R apply to new grants and to grants that were outstanding as of the effective date and are subsequently modified. Estimated compensation expense for grants that were outstanding as of the effective date will be recognized over the remaining vesting period using the compensation cost estimated for the SFAS 123R pro forma disclosures.

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        The adoption of SFAS 123R had a material impact on our consolidated financial position and results of operations. See Note 8 of our Consolidated Financial Statements for further information regarding our stock-based compensation assumptions and expenses, including pro forma disclosures for prior periods as if we had recorded stock-based compensation expense during such periods.

        During the first quarter of 2006, we also adopted SFAS No. 154, "Accounting Changes and Error Corrections—a Replacement of APB Opinion No. 20 and FASB Statement No. 3," which became effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. This Statement applies to all voluntary changes in accounting principle. When a pronouncement includes specific transition guidance, those provisions should be followed. This statement requires retrospective application to prior periods' financial statements of changes in accounting principle, unless it is impracticable to determine either the period-specific effects or the cumulative effect of the change. There have been no accounting changes or error corrections required since our adoption of this pronouncement that required retroactive restatements.

        In September 2006, the SEC issued Staff Accounting Bulletin (SAB) No. 108, "Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements," which became effective for fiscal years ending after November 15, 2006. SAB No. 108 requires that companies utilize a "dual-approach" to assessing the quantitative effects of financial statements misstatements. The dual approach includes both an income statement-focused and balance sheet-focused assessment. To date, implementation of this guidance has not had any significant impact on our financial position or results of operations.

        In July 2006, the FASB issued Interpretation No. 48, "Accounting for Uncertainty in Income Taxes," to create a single model to address accounting for uncertainty in tax positions. We adopted Interpretation No. 48 as of the first quarter of 2007. Interpretation No. 48 requires the use of a two-step approach for recognizing and measuring tax benefits taken or expected to be taken in a tax return, as well as enhanced disclosures regarding uncertainties in income tax positions, including a roll forward of tax benefits taken that do not qualify for financial statement recognition. Refer to Note 9—Income Taxes to our 2007 consolidated financial statements included in Item 8 of this Form 10-K for more information regarding our application of Interpretation No. 48 and its impact on our consolidated financial statements.

Recently Issued Accounting Pronouncements and Regulations

        None

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Results of operations

Comparison of Year ended December 31, 2007 and 2006

 
  Year ended December 31,
 
 
  2007
  2006
  $ Change
  % Change
 
 
  (in thousands)

 
Revenue   $ 1,389   $ 969   $ 420   43 %
Cost of goods sold     1,248     845     403   48 %
   
 
 
 
 
Gross margin     141     124     17   14 %
Selling, general and administrative     5,876     6,508     (632 ) (10 )%
Research and development     8,387     4,748     3,639   77 %
Loss on contract commitments     (578 )   1,385     (1,963 ) (142 )%
Depreciation and amortization     145     96     49   51 %
Casualty loss (recovery)     (69 )   69     (138 ) (200 )%
Interest and other income (expense), net     702     519     183   35 %
   
 
 
 
 
Net loss   $ (12,918 ) $ (12,163 ) $ (755 ) (6 )%
   
 
 
 
 

Revenue

        The following table provides details of our revenues for the twelve months ended December 31, 2007 and 2006.

 
   
  Year ended
December 31,

  Cumulative
Contract
Value
Earned as
of 2007

   
 
  Percent
complete

  Total
Contract
Value

 
  2007
  2006
 
   
  (dollars in thousands)

CEC   100 % $ 78   $ 226   $ 1,233   $ 1,233
NYSERDA PON 846   100 %   81     235     646     646
NYSERDA PON 800   82 %   (1 )   32     51     63
Air Force Research Laboratory   100 %   488     263     750     750
Sandia DOE Earmark   100 %   677     75     752     752
       
 
 
 
  Total Contract Revenue         1,323     831     3,432     3,444
Inverters and accessories         66     138        
       
 
 
 
Total       $ 1,389   $ 969   $ 3,432   $ 3,444
       
 
 
 

        In the year ended December 31, 2007, we completed all but one of our research and development contracts, and recorded revenue using the percentage of completion method of approximately $1,323,000. In addition, we recorded revenue of approximately $66,000 from the sale of Smart Power M5™ inverter systems and related products. In 2006 we recorded revenue from flywheel-related government contracts of approximately $831,000 and approximately $138,000 from the sale of Smart Power M5 inverter systems and related products. Contract revenue was higher in 2007 compared to 2006 by approximately $492,000, or 59%, primarily the result of the completion of our contracts with the Air Force Research Laboratory and with the U.S. Department of Energy (DOE), (administered by Sandia National Laboratories). The purpose of the Sandia DOE contract was to design a 20-megawatt Smart Energy Matrix™ frequency regulation facility. This project directly supported our plan to develop a commercial-scale flywheel-based frequency regulation facility in 2008.

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Cost of Goods Sold

        Cost of goods sold in 2007 includes costs incurred in performance of government contracts calculated on the percentage of completion method in the amount of approximately $1,247,000 and the cost of materials, labor, overheads and warranty accruals for inverter products sold in the amount of approximately $1,000.

Selling, general and administrative expenses

 
  Year ended December 31,
 
 
  (in thousands)

 
Period Ended December 31, 2006   $ 6,508  
Increases (decreases):        
  Salaries and benefits     216  
  Facility costs     90  
  Hiring expenses     23  
  Travel     20  
  Telephone     16  
  Reduction of bad debt reserve     (22 )
  Audit fees     (26 )
  Trade shows     (27 )
  Other     (23 )
  Office upgrades and equipment repairs     (45 )
  Subcontractors and consultants     (122 )
  Public company expenses     (142 )
  Allocation of overhead to contracts     (160 )
  Stock compensation expense     (430 )
   
 
Period Ended December 31, 2007   $ 5,876  
   
 

        Selling, general and administrative expenses totaled approximately $5,876,000 and $6,508,000 for the years ended December 31, 2007, and 2006, respectively. The reduction of approximately $632,000 or 9.7% was primarily the result of lower stock compensation of approximately $430,000 mainly due to a decrease in the Black Scholes value of options issued in 2007 compared to the valuation for options issued during the prior year, a reduction in public company expenses of approximately $142,000, a reduction in the usage of subcontractors and consultants of approximately $122,000, allocation of G&A overhead to our Sandia contract of approximately $160,000, a reduction in audit fees of approximately $26,000, upgrades to office equipment expense during 2006 of approximately $33,000 and reductions of other various items of approximately $84,000. These decreases were partially offset by increases in the following: headcount-related expense of approximately $216,000, facility costs of approximately $90,000, hiring expenses of approximately $23,000, telephone expense of approximately $16,000 and travel expense of $20,000. Overall, we expect our selling, general and administrative expenses for fiscal 2008 to be higher than in 2007 due to increased marketing and sales expenses associated with flywheel products, fund-raising efforts, and hiring of administrative staff to support our move to production.

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Research and Development Expenses

 
  Year ended December 31,
 
 
  (in thousands)

 
Period Ended December 31, 2006   $ 4,748  
Increases (decreases):        
  Salaries and benefits     1,214  
  Facility costs     681  
  Consultants and subcontractors     414  
  Allocation of overhead to contracts     326  
  Costs related to facility move     299  
  Expense materials     419  
  Legal     239  
  Hiring expenses     41  
  Outside testing     41  
  Travel     20  
  Other     10  
  Stock compensation expense     (65 )
   
 
Period Ended December 31, 2007   $ 8,387  
   
 

        For the year ended December 31, 2007, research and development expenses increased by approximately $3.6 million or 77%, in comparison to the equivalent period in 2006. This increase is primarily due to increased expenses of approximately $1,214,000 for headcount-related expenses resulting from the hiring of engineering personnel during the latter half of 2006 to support our flywheel development and testing, increased facility costs of approximately $681,000 related to the cost of operating facilities in both Tyngsboro and Wilmington during the transition period, increased usage of consultants of approximately $414,000, allocation of overhead to contracts of approximately $326,000 less than during the equivalent period in 2006, costs related to the facility move of approximately $299,000, increases in expense materials used in the development of our Smart Energy 25 flywheel of approximately $419,000, legal costs of approximately $239,000 related primarily to the defense of our patents, hiring expense of $41,000, outside testing of $41,000, travel of $20,000, other expenses of approximately $10,000. These increases were partially offset by decreased stock compensation expense of approximately $65,000 based on lower Black Scholes valuations for options issued during the early portion of 2007. In December 2006, we experienced a flywheel malfunction during testing in one of our test cells which resulted in damage to some research and development materials, test equipment, facility and the prototype flywheel being tested. During 2007 we recovered essentially all of the costs associated with the malfunction from our insurance carriers. The insurance proceeds were used to offset previously recorded casualty losses and to offset the costs of expensed materials used to build the prototype flywheel. In addition to costs associated with the malfunction, we spent approximately $61,000 to investigate the cause of the malfunction and to insure that the necessary modifications were implemented to prevent similar malfunctions in the future. These costs are included in the increased cost shown for consultants and subcontractors, above.

        We expect research and development costs during 2008 to be higher than in 2007. Although critical testing of the Smart Energy 25 flywheel is complete, we continue to perform various operational tests and other development work aimed at achieving manufacturing cost reductions. Additionally, we expect occupancy costs in our new, larger facility in Tyngsboro to be higher than those at our Wilmington facility.

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Loss on Contract Commitments

        Our contracts have been primarily for the development of demonstration units of new products and the design of a frequency regulation plant. As such, the work has supported our core research and development efforts. Most of these contracts have been structured on a cost-share basis, for which the expected cost share has been recorded as a contract loss. We recorded contract commitment losses on our research and development contracts in 2005 of $1,535,000 based on expected cost overruns related to material, labor and overhead required to complete the contracts. During 2006, we recorded additional charges totaling approximately $1,385,000 to the contract loss reserve. This amount consisted of net increases in estimated material, labor, overhead and travel costs expected to complete existing contracts along with our expected cost share portion of the Sandia contract. By the end of 2007, all but one smaller government contract was complete. We recorded a reduction to the losses on contract commitments of approximately $578,000, based on the actual cost to complete these contracts, which was less than previously estimated. This amount consisted of net decreases in material, labor, overhead and travel costs required to complete existing contracts of approximately $465,000. In addition, since our actual overhead rate was lower than forecasted at the beginning of the fiscal year, we reduced the overhead applied to the contracts and our contract loss reserve by an additional $113,000.

Depreciation and Amortization

        The increase in depreciation expense for the year ended December 31, 2007 as compared to the same period in 2006 of approximately $49,000, or 51%, is primarily attributable to depreciation on new assets acquired during 2007 and the latter half of 2006. We expect depreciation for 2008 to be substantially higher than during 2007 primarily due to capital expenditures relating to leasehold improvements at our new manufacturing and office facility in Tyngsboro as well as the purchase of machinery and equipment required to begin commercial production. In addition, we will begin to depreciate assets associated with our frequency regulation facilities that we expect to begin commercial operation in the fourth quarter of 2008.

Interest and Other Income / (Expense), net

        Interest income for the year ended December 31, 2007, was approximately $188,000 greater than for the equivalent period in 2006. The primary reason for this difference is that cash balances available for investing were on average higher than during the same period in the prior year, primarily as a result of the cash obtained through the sale of stock and warrants at various times during 2007. The increased interest income was offset by decreases in other income of approximately $5,000.

Net Loss

        As a result of the changes discussed above, the net loss for the year ended December 31, 2007, was approximately $12,918,000, as compared to a net loss during the same period in 2006 of approximately $12,163,000. This represents an increase in net loss of approximately $755,000, or 6%. The increase in the loss for the year is due primarily to the factors discussed above, particularly increased spending on Research and Development activities, facility costs related to the move to the Tyngsboro facility and the temporary maintenance of two facilities, partially offset by decreases in Selling, General and Administrative expenses and the reduction in Contract Loss recorded during 2007.

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Comparison of Year ended December 31, 2006 and 2005

 
  Year ended December 31,
 
 
  2006
  2005
  $ Change
  % Change
 
 
  (in thousands)

 
Revenue   $ 969   $ 1,487   $ (518 ) (35 )%
Cost of goods sold     845     1,575     (730 ) (46 )%
   
 
 
 
 
Gross margin     124     (88 )   212   241 %
Selling, general and administrative     6,508     6,334     174   3 %
Research and development     4,748     1,408     3,340   237 %
Loss on contract commitments     1,385     1,535     (150 ) (10 )%
Depreciation and amortization     96     83     13   16 %
Casualty Loss     69         69   0 %
Interest and other income (expense), net     519     136     383   282 %
   
 
 
 
 
Net loss   $ (12,163 ) $ (9,312 ) $ (2,851 ) (31 )%
   
 
 
 
 

Revenue

        The following table provides details of our revenues for the twelve months ended December 31, 2006 and 2005.

 
   
  Year ended December 31,
   
   
 
   
  Cumulative
Contract
Value
Earned

   
 
  Percent
complete

  Total
Contract
Value

 
  2006
  2005
 
   
  (dollars in thousands)

CEC   94 % $ 226   $ 929   $ 1,155   $ 1,233
NYSERDA PON 846   88 %   235     330     565     646
Bechtel Bettis   100 %       71     98     98
NYSERDA PON 800   84 %   32     21     52     63
Air Force Research Laboratory   35 %   263         263     750
Sandia DOE Earmark   10 %   75         75     752
       
 
 
 
  Total Contract Revenue         831     1,351     2,208     3,542
Inverter and accessories         138     136        
       
 
 
 
Total       $ 969   $ 1,487   $ 2,208   $ 3,542
       
 
 
 

        In the year ended December 31, 2006, we recorded revenue from flywheel-related research and development contracts using the percentage of completion method of approximately $831,000 and approximately $138,000 from the sale of Smart Power M5™ inverter systems and related products. In 2005 we recorded revenue from flywheel-related government contracts of approximately $1,351,000 and recorded approximately $136,000 from the sale of Smart Power M5 inverter systems and related products. Contract revenue was lower in 2006 compared to 2005 by approximately $520,000, or 38%, primarily the result of the completion of the majority of the milestones on our demonstration contracts with CEC and NYSERDA in 2005. This decrease was partially offset by revenue on a contract awarded in September 2006 from the U.S. Department of Energy (DOE), to be administered by Sandia National Laboratories. The purpose of this contract is to design a 20-megawatt Smart Energy Matrix™ frequency regulation facility. This project directly supports our plan to develop a commercial-scale flywheel-based frequency regulation facility in 2008. The Sandia contract, valued at $752,500 over a 12-month period, will provide funding for a portion of our expected development cost.

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Cost of Goods Sold

        Cost of goods sold in 2006 includes costs incurred in performance of government contracts calculated on the percentage of completion method in the amount of approximately $831,000 and the cost of materials, labor, overheads and warranty accruals for inverter products sold in the amount of approximately $14,000.

Selling, General and Administrative Expenses

 
  Amount
 
 
  (in thousands)

 
Year ended December 31, 2005   $ 6,334  
Increases (Decreases):        
  Subcontractors and consultants     (748 )
  Legal and professional fees     (700 )
  Public company expenses     (149 )
  Audit fees     (37 )
  Stock compensation expense     1,609  
  Salaries and benefits     70  
  Office equipment upgrades     36  
  Other     93  
   
 
Year ended December 31, 2006   $ 6,508  
   
 

        In total, selling, general and administrative costs increased 2.7%, or approximately $174,000 from 2005 to 2006. Increases were primarily related to the following: non-cash stock compensation of approximately $1,609,000 due to the implementation of FAS123R; salaries and benefits of additional staff of approximately $70,000; computer upgrades of approximately $36,000; and other expenses which were primarily related to our preparations for the requirements of Section 404 of the Sarbanes Oxley Act of 2002. These increases were partially offset by non-recurring costs that were incurred in 2005 related to a possible acquisition that ultimately was not completed. Costs associated with the potential acquisition were legal and professional fees of approximately $700,000; subcontractor and consultant costs of approximately $748,000, public company expenses of approximately $149,000, and audit fees of approximately $37,000.

Research and Development Expenses

 
  Amount
 
  (in thousands)

Year ended December 31, 2005   $ 1,408
Increases:      
  Expense materials     1,172
  Salaries and benefits     851
  Stock compensation expense     724
  Engineering and manufacturing overheads applied     157
  Consultants and subcontractors     81
  Facility costs     165
  Software maintenance     78
  Travel     58
  Other     54
   
Year ended December 31, 2006   $ 4,748
   

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        The increase from 2005 to 2006 of approximately $3.3 million or 237% is primarily due to increased expenses for development materials of approximately $1,172,000, increased headcount-related expenses resulting from hiring engineering personnel to support our flywheel development of approximately $851,000, FAS123 non-cash stock compensation expense of approximately $724,000, lower overheads allocated to contracts of approximately $157,000, increased use of consultants of approximately $81,000, higher facility charges of approximately $165,000, higher software maintenance charges of approximately $78,000, increased travel charges of approximately $58,000, and other miscellaneous expenses of approximately $54,000.

Loss on contract commitments

        We recorded contract commitment losses on our research and development contracts in 2005 of $1,535,000 based on expected cost overruns related to material, labor and overhead, as well as unplanned overruns in the amount of labor required to complete the contracts. During 2006, we recorded additional charges totaling approximately $1,385,000 to the contract loss reserve. This amount consists of our expected cost share for the Sandia contract of approximately $240,000; increases in estimated material, labor, and travel costs expected to be needed to complete existing contracts of approximately $314,000; increases in the labor and overhead rates applied to the contracts based on actual costs of approximately $786,000, and other costs of $45,000.

Depreciation and Amortization

        Depreciation expense in 2006 was approximately $13,000, or 16% higher in 2006 than in 2005, due primarily to depreciation on new assets acquired during the latter half of 2005, upgrades to our office equipment, and capital expenditures in 2006 to develop our production capability for the Smart Energy 25.

Casualty loss

        On December 28, 2006, a malfunction occurred during the testing of a Smart Energy 25 flywheel which resulted in the loss of the flywheel and other inventory in the area (which had previously been expensed), as well as minor damage to the building improvements and other equipment. A casualty loss of approximately $69,000 was recorded for the estimated cost of repairs to the building improvements of approximately $34,000, repair fixed assets of approximately $18,000, replace damaged supplier equipment of $6,000 and perform necessary clean up of approximately $11,000.

Interest and Other Income/(Expense), net

        Interest and other income increased by approximately $383,000, or 282% from 2005 to 2006, primarily due to the increase in interest income due to higher cash balances. This increase was offset by the write-back of an officer loan reserve in 2005 of approximately $102,000, and lower gains on the sale of equipment.

Net Loss

        As a result of the changes discussed above, the net loss for 2006 was approximately $12,163,000 which compares to a net loss in 2005 of approximately $9,312,000, an increase in net loss of approximately $2,851,000 or 31%.

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Liquidity and Capital Resources

 
  Year ended December 31,
 
 
  2007
  2006
 
 
  (in thousands)

 
Cash and cash equivalents   $ 30,417   $ 5,251  
Working capital     28,820     3,310  
Cash provided by (used in)              
  Operating activities     (11,282 )   (8,442 )
  Investing activities     (6,930 )   (272 )
  Financing activities     43,378     75  
   
 
 
Net decrease in cash and cash equivalents   $ 25,166   $ (8,639 )
   
 
 
Current ratio     9.1     2.0  
   
 
 

        Our cash requirements depend on many factors including, but not limited to, cost to build our flywheels and frequency regulation facilities, research and development activities, facility costs as well as general and administrative expenses. Since we are still in the development stage and have not yet begun our principal operations, we do not generate enough cash from operations to satisfy our working capital requirements. We expect to make significant expenditures to fund our operations, develop technologies and explore opportunities to find and develop additional markets to sell our products. In previous years, we took significant actions to reduce our cash expenditures for product development, infrastructure and production readiness by significantly reducing headcount, development spending and capital expenditures. However, as we near completion of development of the Smart Energy Matrix™ and prepare to begin commercial activity aimed at revenue generation in 2008, we have begun to increase our headcount, and have spent additional funds on expense materials, capital equipment and market analyses to understand the size of markets, competitive aspects and advantages that our products could provide. We expect to use more cash resources during 2008 as we work to develop the capacity to manufacture our Smart Energy 25 flywheels in anticipation of having a frequency regulation facility in service at two ISOs during the fourth quarter of 2008.

        We must raise additional equity to execute our business plan. Based on our rate of expenditure of cash and the additional expenditures expected to support our business plan, we have sufficient cash to fund operations into approximately the fourth quarter of 2008. We need to obtain additional cash during 2008 to fund:

    Our continuation as a going concern

    Ongoing research and development of the Smart Energy 25 flywheel and the Smart Energy Matrix™ multi-flywheel system

    The ramp up of our manufacturing and assembly capacity

    The build-out of facilities to provide frequency regulation services to the electricity grid

    Working capital requirements; and

    The identification and development of new business opportunities.

        We are continuing to develop the Smart Energy 25 flywheel, which is the core component of the Smart Energy Matrix™ flywheel system. In order to complete development of the Smart Energy Matrix™ flywheel system, build, operate and receive fees for frequency regulation services of at least one megawatt from our flywheel-based commercial frequency regulation system and have sufficient working capital to continue to execute our business plan through 2008, in addition to the $42.6 million raised in 2007, we will need to raise approximately $20 million of funding during the remainder of

38


2008. Also, to achieve our out-year deployment plan for additional frequency regulation facilities, we will need to raise additional capital either from project finance or additional equity transactions.

Operating activities

        Net cash used in operating activities was approximately $11,282,000, $8,441,000 and $8,923,000 for the twelve months ended December 31, 2007, 2006 and 2005, respectively. The primary component to the negative cash flow from operations is from net losses. Net loss for 2007 was approximately $12,918,000. Cash used by operations was partially reduced by an insurance recovery of approximately $336,000 relating to a malfunction that occurred in December 2006 during testing of a prototype flywheel. In addition, the net operating loss was partially offset by non-cash charges of approximately $1,838,000 and $144,000 for stock compensation expense and depreciation, respectively. Changes in operating assets and liabilities generated approximately $521,000 in cash which were more than offset by deferred rent of approximately $517,000 expenses paid against a previously-recorded restructuring reserve of approximately $347,000, and a gain on sales of fixed assets of approximately $3,000.

        Net loss for 2006 was approximately $12,163,000. This loss was offset by non-cash charges of approximately $2,333,000, $96,000 and $18,000 for stock compensation expense, depreciation and an increase in the asset impairment reserve, respectively. Changes in operating assets and liabilities generated approximately $1,641,000 of cash, which was partially offset by expenses paid against a previously-recorded restructuring reserve of approximately $366,000.

        For 2005, we had a net loss of approximately $9,312,000. This included facility-related cash payments charged against restructuring reserves of approximately $349,000, reductions to the asset impairment reserve for disposed fixed assets of approximately $122,000, a reversal of a portion of the reserved note to our former CEO of approximately $102,000, offset by non-cash employee stock compensation of approximately $645,000 and depreciation and amortization of approximately $83,000. Changes in operating assets and liabilities generated approximately $234,000 of cash during 2005.

Investing Activities

        Net cash generated by (used) in investing activities was approximately ($6,930,000), ($272,000) and $176,000 for 2007, 2006 and 2005, respectively. The primary use of cash for both 2007 and 2006 was the purchase of property and equipment of approximately $6,734,000 and $317,000, respectively. The 2007 capital additions include approximately $5,782,000 which is classified as "Construction in Progress" as of the end of December 2007, most of which relates to the build-out of the Tyngsboro facility. Approximately $453,000 of the additions relate to production material which has been purchased to build flywheels for commercial use in our frequency regulation facilities. In 2007, we increased restricted cash by $200,000 (related to the Tyngsboro lease.) Proceeds from the sale of equipment provided approximately $4,000 in cash in 2007.

        In 2006, the capital additions were partially offset by reductions of restricted cash of approximately $45,000.

        The principal source of cash during 2005 was proceeds from the sale of property and equipment of approximately $127,000 and a reduction of restricted cash of approximately $90,000, partially offset by the purchase of capital equipment of approximately ($41,000).

Financing Activities

        Net cash generated by financing activities was approximately $43,378,000, $75,000 and $17,540,000 for 2007, 2006 and 2005, respectively. During 2007, we raised approximately $42,550,000 from the sale of our stock, approximately $717,000 for stock and warrants issued to the landlord, approximately

39



$85,000 for the exercise of employee stock options and approximately $26,000 for the issuance of stock to our employees under the employee stock purchase plan.

        For 2006, approximately $54,000 in cash was provided by the exercise of employee stock options, along with approximately $21,000 received for shares issued under the employee stock purchase plan.

        For 2005 the primary source of cash was proceeds from the issuance of our common stock in two separate PIPE transactions in the amount of approximately $17,108,000, exercise of stock options of approximately $713,000, the expensing of capitalized deferred financing costs for a failed business combination of approximately $328,000 and approximately $4,000 for shares issued under our employee stock purchase plan, offset by purchases of our common stock to treasury of ($613,000).

        As part of our new business development, we may evaluate possible acquisitions of enterprises or technologies that we consider synergistic from a market, technology or product perspective. We may make investments in companies for strategic business reasons. Because our primary motivation in making these investments may not be to realize a profit on the investment itself, but rather to expand our business prospects, these investments may lack any financial return to the Company and may result in a loss of principal and may impair our liquidity.

        The following table summarizes our commitments at December 31, 2007:

 
  Description of Commitment
 
  Operating
leases

  Purchase
Obligations

  Total
Year ending:                  
  December 31, 2007   $   $ 4,971,921   $ 4,971,921
  December 31, 2008     503,687           503,687
  December 31, 2009     701,687           701,687
  December 31, 2010     727,437           727,437
  December 31, 2011     753,188           753,188
  December 31, 2012     778,937           778,937
  Thereafter     1,422,689           1,422,689
   
 
 
  Total Commitments   $ 4,887,625   $ 4,971,921   $ 9,859,546
   
 
 

        At December 31, 2007, we had firm commitments with our suppliers of approximately $5.0 million. These commitments are for components for our commercial flywheel systems, completion of the build-out of the Tyngsboro facility, and to satisfy contractual obligations for our research and development programs.

        In July 2007, we signed a seven-year lease on a new corporate headquarters that significantly expanded our manufacturing capacity and provides sufficient space to continue our research and development activities. The amounts listed for operating leases represent payments for the occupancy of our principal executive offices, laboratory and manufacturing facilities located at 65 Middlesex Road Tyngsboro, Massachusetts. This 103,000 square foot facility has manufacturing capacity for the production of up to 600 flywheels per year. We have a second phase manufacturing build-out planned that will increase annual manufacturing capacity to more than 1,000 flywheels. The lease on our previous facility in Wilmington, MA expired at the end of November 2007.

        As part of the Tyngsboro lease agreement, we issued to the landlord 150,000 shares of our common stock pursuant to our registration statement on Form S-3 filed on August 17, 2007, which we amended on August 27, 2007 and became effective on August 28, 2007, and a warrant exercisable for 500,000 shares of our common stock pursuant to an exemption from registration under the Securities Act of 1933, as amended, in return for lower cash payments payable by us under the lease. We have provided the Wilmington and Tyngsboro lessors with irrevocable letters of credit securing our

40



performance under these leases with a balance at December 31, 2007 of $374,346, which are reduced periodically during the lease terms. These letters of credit are secured by a cash deposit, which is included in restricted cash in the accompanying consolidated balance sheets. In addition, we are responsible for real estate taxes and all operating expenses of the Tyngsboro facility.

        In the future, additional capital expenditures will be required for a phase two build-out of manufacturing capacity. The amount and timing of these expenditures are dependent on requirements of equipment needed to meet production schedules as well as having sufficient funding.

        By the end of 2007, we had substantially completed all critical performance tests on the Smart Energy 25 flywheel, and as a result we have placed orders for materials required to build our first 10 commercial flywheel units.

Financing

        In February 2007, we sold 11,814,687 units of the Company at a purchase price of $0.90 per unit. Each unit consisted of one share of our common stock, par value $0.01 per share, and a warrant to purchase 0.5 shares of common stock at an exercise price of $1.33 per share, for a total of 6,261,786 warrants. As part of the transaction, 354,441 warrants were issued to the placement agent. The units were issued pursuant to a prospectus supplement filed with the Securities and Exchange Commission in connection with our registration statement on Form S-3 filed on September 1, 2006, which became effective on December 14, 2006. We filed a request with the Securities and Exchange Commission on August 1, 2007 that this registration statement on Form S-3 be withdrawn and the unsold securities deregistered, and filed a new shelf registration statement on Form S-3 for $50 million on August 6, 2007, which we amended on August 14, 2007 and became effective on August 15, 2007.

        In July 2007 we entered into a lease for a new facility in Tyngsboro, MA. We agreed under the terms of the lease to issue to the landlord pursuant to an exemption from registration under the Securities Act of 1933, as amended, a warrant exercisable for 500,000 shares of our common stock at an exercise price of $1.77 per share. The warrant and the shares issuable upon exercise of the warrant are restricted securities and may not be sold without registration under the Securities Act of 1933, as amended, and applicable state securities laws or an exemption there from. In addition, we issued the landlord 150,000 shares of common stock.

        In September 2007, we sold 5,102,041 units of the Company at a purchase price of $1.96 per unit. Each unit consisted of one share of our common stock, par value $0.01 per share, and a warrant to purchase 1.2 shares of common stock at an exercise price of $1.99 per share, for a total of 6,122,449 warrants. In addition, 153,061 warrants were issued to the placement agents at the same price per share. The units were issued pursuant to a prospectus supplement filed with the Securities and Exchange Commission in connection with our registration statement on Form S-3 for $50 million filed on August 6, 2007, which we amended on August 14, 2007 and became effective on August 15, 2007.

        In October 2007, we sold 11,911,852 units of the Company at a purchase price of $2.10 per unit, for a total of approximately $23.8 million, net of expenses. Each unit consisted of one share of our common stock, par value $0.01 per share, and a warrant to purchase 0.95 shares of common stock at an exercise price of $2.97 per share, for a total of 11,316,260 warrants. The units were issued pursuant to a prospectus supplement filed with the Securities and Exchange Commission in connection with our registration statement on Form S-3 for $50 million filed on August 6, 2007, which we amended on August 14, 2007 and became effective on August 15, 2007.

        There were no significant financing activities during 2006.

        Inasmuch as we are not expecting to become cash flow positive until at least 2010, our ability to continue as a going concern will depend on our ability to raise additional capital. We may not be able to raise this capital at all, or if it we are able to do so, it may be on terms that are adverse to

41



shareholders. We believe that project debt financing may be available to us to meet some portion of our cash requirements for 2008.

Inflation

        Our operations have not been materially affected by inflation.

Off-balance Sheet Arrangements

        We have no off-balance sheet arrangements.

Item 7A.    Quantitative and Qualitative Disclosures about Market Risk

        Our cash equivalents and investments, all of which have maturities of less than ninety days, could expose us to interest rate risk. At December 31, 2007, we had approximately $109,000 of cash equivalents that were held in a non-interest bearing checking account. Also at December 31, 2007 we had approximately $30.3 million of cash equivalents that were held in interest-bearing money market accounts at high-quality financial institutions, some of which are invested in off-shore securities. The fair value of these investments approximates their cost. A 10% change in interest rates would change the investment income realized on an annual basis by approximately $114,500, which we do not believe is material. The funds invested in money market accounts may not be covered under FDIC Insurance, and therefore may be at some risk of loss.

42


Item 8.    Financial Statements and Supplementary Data


BEACON POWER CORPORATION AND SUBSIDIARY
(A Development Stage Company)
Index to Consolidated Financial Statements

 
  Page
Report of Independent Registered Public Accounting Firm   44

Consolidated Balance Sheets at December 31, 2007 and 2006

 

46

Consolidated Statements of Operations for the years ended December 31, 2007, 2006 and 2005 and for the period from May 8, 1997 (date of inception) to December 31, 2007

 

47

Consolidated Statements of Stockholders' Equity for the years ended December 31, 2007, 2006 and 2005 and for the period from May 8, 1997 (date of inception) to December 31, 2007

 

48

Consolidated Statements of Cash Flows for the years ended December 31, 2007, 2006 and 2005 and for the period from May 8, 1997 (date of inception) to December 31, 2007

 

52

Notes to Consolidated Financial Statements

 

53

43



Report of Independent Registered Public Accounting Firm

To the Stockholders and Board of Directors
Beacon Power Corporation:

        We have audited the accompanying consolidated balance sheets of Beacon Power Corporation and Subsidiary (the "Company") (a development stage company) as of December 31, 2007 and 2006, and the related consolidated statements of operations, stockholders' equity and cash flows for each of the years in the three-year period ended December 31, 2007 and for the period from May 8, 1997 (date of inception) through December 31, 2007. We have also audited the Company's internal control over financial reporting as of December 31, 2007 based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company's management is responsible for these consolidated financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting appearing under Item 9A, included in the accompanying Management's Report on Internal Controls Over Financial Reporting. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and an opinion on the Company's internal control over financial reporting based on our audits.

        We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the consolidated financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.

        A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements.

        Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

44


        In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Beacon Power Corporation and Subsidiary as of December 31, 2007 and 2006 and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2007 and the period from May 8, 1997 (date of inception) through December 31, 2007 in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, Beacon Power Corporation maintained, in all material respects, effective internal control over financial reporting as of December 31, 2007, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).

        The accompanying consolidated financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 1 to the consolidated financial statements, the Company's recurring losses from operations and negative operating cash flows raise substantial doubt about its ability to continue as a going concern. Management's plans concerning these matters are also described in Note 2. The consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty.

/s/ MILLER WACHMAN LLP
   

Boston, Massachusetts
March 13, 2008

45



BEACON POWER CORPORATION AND SUBSIDIARY

(A Development Stage Company)

Consolidated Balance Sheets

 
  December 31,
2007

  December 31,
2006

 
Assets              
Current assets:              
  Cash and cash equivalents   $ 30,417,095   $ 5,251,337  
  Accounts receivable, trade, net     424,788     506,402  
  Unbilled costs on contracts in progress     82,195     133,240  
  Prepaid expenses and other current assets     1,475,084     777,276  
   
 
 
    Total current assets     32,399,162     6,668,255  
Property and equipment, net     7,004,021     415,406  
Restricted cash     374,346     174,346  
   
 
 
Total assets   $ 39,777,529   $ 7,258,007  
   
 
 
Liabilities and Stockholders' Equity              
Current liabilities:              
  Accounts payable   $ 296,463   $ 453,077  
  Accrued compensation and benefits     1,024,874     456,075  
  Other accrued expenses     2,183,217     834,832  
  Advance billings on contracts     7,222     445,719  
  Accrued contract loss     67,419     821,032  
  Restructuring reserve         347,408  
   
 
 
    Total current liabilities     3,579,195     3,358,143  
   
 
 

Commitments and contingencies (Note 5)

 

 

 

 

 

 

 

Stockholders' equity:

 

 

 

 

 

 

 
  Preferred Stock, $.01 par value; 10,000,000 shares authorized; no shares issued or outstanding          
  Common stock, $.01 par value; 200,000,000 shares authorized; 88,658,967 and 59,524,687 shares issued and outstanding at December 31, 2007 and December 31, 2006, respectively     886,590     595,247  
  Additional paid-in-capital     199,351,427     154,426,395  
  Deficit accumulated during the development stage     (163,326,844 )   (150,408,939 )
  Treasury stock, 421,692 shares at cost     (712,839 )   (712,839 )
   
 
 
    Total stockholders' equity     36,198,334     3,899,864  
   
 
 
Total liabilities and stockholders' equity   $ 39,777,529   $ 7,258,007  
   
 
 

See notes to consolidated financial statements.

46



BEACON POWER CORPORATION AND SUBSIDIARY

(A Development Stage Company)

Consolidated Statements of Operations

 
  2007
  2006
  2005
  Cumulative from
May 8, 1997
(date of inception)
through
December 31,
2007

 
Revenue   $ 1,388,834   $ 968,577   $ 1,487,258   $ 4,720,547  
Cost of goods sold     1,248,048     845,102     1,575,240     5,126,259  
   
 
 
 
 
Gross profit (loss)     140,786     123,475     (87,982 )   (405,712 )
Operating expenses:                          
  Selling, general and administrative     5,875,827     6,508,375     6,334,219     50,974,395  
  Research and development     8,387,025     4,747,685     1,408,233     68,418,488  
  Loss on contract commitments     (577,789 )   1,384,978     1,534,298     2,717,461  
  Depreciation and amortization     144,424     95,669     83,031     4,461,090  
  Casualty loss (recovery)     (69,084 )   69,084          
  Restructuring charges                 2,159,280  
  Loss on impairment of assets                 4,663,916  
   
 
 
 
 
    Total operating expenses     13,760,403     12,805,791     9,359,781     133,394,630  
   
 
 
 
 
Loss from operations     (13,619,617 )   (12,682,316 )   (9,447,763 )   (133,800,342 )
Other income (expense):                          
  Interest income     688,621     500,468     162,044     5,234,008  
  Interest expense                 (1,093,703 )
  Gain on sale of investment                 3,562,582  
  Other income (expense)     13,091     18,410     (26,385 )   (223,195 )
   
 
 
 
 
    Total other income (expense), net     701,712     518,878     135,659     7,479,692  
   
 
 
 
 
Net loss     (12,917,905 )   (12,163,438 )   (9,312,104 )   (126,320,650 )
Preferred stock dividends                 (36,825,680 )
Accretion of convertible preferred stock                 (113,014 )
   
 
 
 
 
Loss to common shareholders   $ (12,917,905 ) $ (12,163,438 ) $ (9,312,104 ) $ (163,259,344 )
   
 
 
 
 
Loss per share, basic and diluted   $ (0.18 ) $ (0.21 ) $ (0.20 )      
   
 
 
       
Weighted-average common shares outstanding     73,604,198     59,080,224     47,665,868        
   
 
 
       

See notes to consolidated financial statements.

47


BEACON POWER CORPORATION AND SUBSIDIARY
(A Development Stage Company)
Consolidated Statements of Stockholders' Equity

 
  Class A
Preferred Stock

  Class C
Preferred Stock

   
   
   
   
 
 
  Common Stock
   
   
 
Description

  Deferred
Consulting
Expense

  Deferred
Stock
Compensation

 
  Shares
  Amount
  Shares
  Amount
  Shares
  Amount
 
BALANCE AT MAY 8, 1997 (DATE OF INCEPTION)     $     $     $   $   $  
Issuance of Founder's Shares               6,750,000     67,500          
Issuance of Class A preferred stock   1,390,000     5,662,500                 (275,000 )    
Recapitalization   3,373,313     67,466         (6,746,626 )   (67,466 )        
Rounding for fractional shares               (2 )            
Issuance of Class C preferred and common stock         6     29,866   13,476     134          
Deferred Consulting                       773,284      
Series A Issuance for Consulting               134,464     1,345     (498,284 )    
Repayment of subscription receivable                            
Issuance of Series A preferred stock for services and interest on loans   4,594     11,485                      
Dividend on preferred stock                            
Accretion of redeemable preferred stock to redemption value                            
Deferred Stock Compensation                           (1,269,445 )
Issuance of stock options for consulting services                           (47,892 )
Issuance of Stock Options to settle lawsuit                            
Issuance of non-employee stock options                            
Amortize Deferred Stock Compensation and issue RSUs               643,160     6,431         2,026,120  
Issuance of warrants                            
Proceeds from stock offering, net of related expenses               9,200,000     92,000          
Conversion of Series A preferred stock   (4,767,907 )   (5,741,451 )       9,535,814     95,358          
Conversion of Series C preferred stock         (6 )   (29,866 ) 12              
Conversion of convertible preferred stock               19,823,704     198,237          
Payment of accrued dividend               859,330     8,593          
Cashless Warrant exercise               1,982,876     19,829          
Exercise of Stock Options               1,481,987     14,820          
Shares issued through ESPP               110,615     1,107          
Option extension for CEO                            
Option extension for severed employees                            
Purchase of Treasury Stock                            
Deferred Stock Compensation revaluation                           (8,948 )
Issuance of restricted stock units for bonus                           (1,407,002 )

See notes to consolidated financial statements.

48


BEACON POWER CORPORATION AND SUBSIDIARY
(A Development Stage Company)
Consolidated Statements of Stockholders' Equity (Continued)

 
  Class A
Preferred Stock

  Class C
Preferred Stock

   
   
   
   
 
 
  Common Stock
   
   
 
Description

  Deferred
Consulting
Expense

  Deferred
Stock
Compensation

 
  Shares
  Amount
  Shares
  Amount
  Shares
  Amount
 
Net loss     $     $     $   $   $  
   
 
 
 
 
 
 
 
 
  Balance, December 31, 2004               43,788,810     437,888         (707,167 )
   
 
 
 
 
 
 
 
 
Deferred stock compensation revaluation                           27,360  
Issuance of restricted stock units for bonus                           (1,063,145 )
Amortize deferred stock compensation and issue RSUs               593,080     5,931         679,807  
Shares issued through ESPP               7,273     73          
Issuance of non-employee stock options                            
Cashless exercise of stock warrants               24,215     242          
Exercise of stock options               965,856     9,658          
Issuance of stock for cash               13,320,802     133,208          
Stock buyback to pay officer loan                            
Net loss                            
   
 
 
 
 
 
 
 
 
  Balance, December 31, 2005               58,700,036     587,000         (1,063,145 )
   
 
 
 
 
 
 
 
 
Issuance of restricted stock units for bonus               696,160     6,961          
Issuance of officer restricted stock units               10,533     106          
Amortize deferred stock compensation and issue RSUs                           1,063,145  
Shares issued through ESPP               17,958     180          
Stock-based compensation                            
Executive performance-based RSU compensation expense                            
Exercise of stock options               100,000     1,000          
Net loss                            
   
 
 
 
 
 
 
 
 
  Balance, December 31, 2006               59,524,687     595,247          
   
 
 
 
 
 
 
 
 
Issuance of officer restricted stock units               32,074     320          
Shares issued through ESPP               33,416     334          
Stock-based compensation                            
Executive performance-based RSU compensation expense                            
Exercise of stock options               90,210     901          
Stock and warrants issued for lease               150,000     1,500          
Issuance of stock for cash, net of issuance costs               28,828,580     288,288          
Net loss                            
   
 
 
 
 
 
 
 
 
  Balance, December 31, 2007     $     $   88,658,967   $ 886,590   $   $  
   
 
 
 
 
 
 
 
 

See notes to consolidated financial statements.

49


BEACON POWER CORPORATION AND SUBSIDIARY
(A Development Stage Company)
Consolidated Statements of Stockholders' Equity (Continued)

 
   
   
   
  Treasury Stock
  Total
Stockholders'
(Deficiency)
Equity

 
Description

  Additional
Paid-in
Capital

  Stock
Subscription
Receivable

  Retained
Deficit

 
  Shares
  Amount
 
BALANCE AT MAY 8, 1997 (DATE OF INCEPTION)   $   $   $     $   $  
Issuance of Founder's Shares             (67,500 )          
Issuance of Class A preferred stock         (5,000,000 )             387,500  
Recapitalization                        
Rounding for fractional shares                        
Issuance of Class C preferred and common stock                       30,000  
Deferred Consulting                       773,284  
Series A Issuance for Consulting     496,939                    
Repayment of subscription receivable         5,000,000               5,000,000  
Issuance of Series A preferred stock for services and interest on loans                       11,485  
Dividend on preferred stock             (2,245,680 )         (2,245,680 )
Accretion of redeemable preferred stock to redemption value             (113,014 )         (113,014 )
Deferred Stock Compensation     1,269,445                    
Issuance of stock options for consulting services     47,892                    
Issuance of Stock Options to settle lawsuit     303,160                   303,160  
Issuance of non-employee stock options     16,288                   16,288  
Amortize Deferred Stock Compensation and issue RSUs     (33,022 )                 1,999,529  
Issuance of warrants     36,520,366         (34,580,000 )         1,940,366  
Proceeds from stock offering, net of related expenses     49,249,537                   49,341,537  
Conversion of Series A preferred stock     5,646,093                    
Conversion of Series C preferred stock     29,866                    
Conversion of convertible preferred stock     36,496,431                   36,694,668  
Payment of accrued dividend     1,077,714                   1,086,307  
Cashless Warrant exercise     (19,829 )                  
Exercise of Stock Options     1,421,446                   1,436,266  
Shares issued through ESPP     127,044                   128,151  
Option extension for CEO     315,394                   315,394  
Option extension for severed employees     31,197                   31,197  
Purchase of Treasury Stock               132,000     (99,660 )   (99,660 )
Deferred Stock Compensation revaluation     8,948                    
Issuance of restricted stock units for bonus     1,407,002                    

See notes to consolidated financial statements.

50


BEACON POWER CORPORATION AND SUBSIDIARY
(A Development Stage Company)
Consolidated Statements of Stockholders' Equity (Continued)

 
   
   
   
  Treasury Stock
  Total
Stockholders'
(Deficiency)
Equity

 
Description

  Additional
Paid-in
Capital

  Stock
Subscription
Receivable

  Retained
Deficit

 
  Shares
  Amount
 
Net loss       $   $ (91,927,203 )   $   $ (91,927,203 )
   
 
 
 
 
 
 
  Balance, December 31, 2004     134,411,911         (128,933,397 ) 132,000     (99,660 )   5,109,575  
   
 
 
 
 
 
 
Deferred stock compensation revaluation     (27,360 )                  
Issuance of restricted stock units for bonus     1,063,145           212,940     (455,838 )   (455,838 )
Amortize deferred stock compensation and issue RSUs     (40,020 )                 645,718  
Shares issued through ESPP     3,842                   3,915  
Issuance of non-employee stock options                        
Cashless exercise of stock warrants     (242 )                  
Exercise of stock options     703,297                   712,955  
Issuance of stock for cash     16,975,269                   17,108,477  
Stock buyback to pay officer loan               76,752     (157,341 )   (157,341 )
Net loss             (9,312,104 )         (9,312,104 )
   
 
 
 
 
 
 
  Balance, December 31, 2005     153,089,842         (138,245,501 ) 421,692     (712,839 )   13,655,357  
   
 
 
 
 
 
 
Issuance of restricted stock units for bonus     (6,961 )                  
Issuance of officer restricted stock units     (106 )                  
Amortize deferred stock compensation and issue RSUs                       1,063,145  
Shares issued through ESPP     20,096                   20,276  
Stock-based compensation     906,488                   906,488  
Executive performance-based RSU compensation expense     363,636                   363,636  
Exercise of stock options     53,400                   54,400  
Net loss             (12,163,438 )         (12,163,438 )
   
 
 
 
 
 
 
  Balance, December 31, 2006     154,426,395         (150,408,939 ) 421,692     (712,839 )   3,899,864  
   
 
 
 
 
 
 
Issuance of officer restricted stock units     (320 )                  
Shares issued through ESPP     25,229                   25,563  
Stock-based compensation     1,293,094                   1,293,094  
Executive performance-based RSU compensation expense     545,456                   545,456  
Exercise of stock options     84,386                   85,287  
Stock and warrants issued for lease     715,114                   716,614  
Issuance of stock for cash, net of issuance costs     42,262,073                   42,550,361  
Net loss             (12,917,905 )         (12,917,905 )
   
 
 
 
 
 
 
  Balance, December 31, 2007   $ 199,351,427   $   $ (163,326,844 ) 421,692   $ (712,839 ) $ 36,198,334  
   
 
 
 
 
 
 

See notes to consolidated financial statements.

51



BEACON POWER CORPORATION AND SUBSIDIARY
(A Development Stage Company)
Consolidated Statement of Cash Flows

 
   
   
   
  Cumulative from
May 8, 1997
(date of inception)
through
December 31,
2007

 
 
  Year ended December 31,
 
 
  2007
  2006
  2005
 
Cash flows from operating activities:                          
  Net loss   $ (12,917,905 ) $ (12,163,438 ) $ (9,312,104 ) $ (126,320,650 )
  Adjustments to reconcile net loss to net cash used in                          
  operating activities:                          
    Depreciation and amortization     144,424     95,669     83,031     4,461,091  
    Loss (gain) on sale of fixed assets     (3,223 )           192,946  
    Impairment of assets, net     553     18,567     (122,186 )   4,551,147  
    (Expenses paid) restructuring charge     (347,408 )   (366,061 )   (349,175 )    
    Reserve for officer's note             (102,044 )    
    Interest expense relating to issuance of warrants                 371,000  
    Non-cash charge for change in option terms                 346,591  
    Non-cash charge for settlement of lawsuit                 303,160  
    Amortization of deferred consulting expense, net                 1,160,784  
    Amortization of deferred stock compensation         1,063,145     645,718     3,699,721  
    Options and warrants issued for consulting services                 1,585,654  
    Services and interest expense paid in preferred stock                 11,485  
    Gain on sale of investments                 (3,562,582 )
    Stock-based compensation     1,838,550     1,270,124         3,108,674  
    Deferred rent     (517,310 )           (517,310 )
  Changes in operating assets and liabilities:                          
    Accounts receivable     81,614     82,038     (536,335 )   (424,788 )
    Inventory             222,593      
    Unbilled costs on government contracts     51,045     304,519     (437,759 )   (82,195 )
    Prepaid expenses and other current assets     (180,498 )   109     142,055     (1,057,434 )
    Accounts payable     (156,614 )   315,787     (251,899 )   296,463  
    Accrued compensation and benefits     568,799     304,757     20,709     1,024,874  
    Advance billings on contracts     (438,497 )   370,899     74,820     7,222  
    Accrued interest                 275,560  
    Accrued loss on contract commitments     (753,613 )   272,418     548,614     67,419  
    Other accrued expenses and current liabilities     1,348,385     (9,910 )   451,173     2,191,887  
   
 
 
 
 
      Net cash used in operating activities     (11,281,698 )   (8,441,377 )   (8,922,789 )   (108,309,281 )
   
 
 
 
 
Cash flows from investing activities:                          
  Purchase of investments                 (1,190,352 )
  Sale of investments                 4,752,934  
  Restricted cash     (200,000 )   45,222     90,443     (374,346 )
  Increase in other assets                 (412,072 )
  Purchases of property and equipment     (6,734,446 )   (317,346 )   (41,851 )   (15,546,196 )
  Sale of property and equipment     4,077         127,357     202,674  
   
 
 
 
 
      Net cash used in investing activities     (6,930,369 )   (272,124 )   175,949     (12,567,358 )
   
 
 
 
 
Cash flows from financing activities:                          
  Initial public stock offering, net of expenses                 49,341,537  
  Stock offerings, net of expenses     42,550,361         17,108,477     59,658,838  
  Payment of dividends                 (1,159,373 )
  Shares issued under employee stock purchase plan     25,563     20,276     3,915     177,904  
  Exercise of employee stock options     85,287     54,400     712,955     2,288,909  
  Cash paid for financing costs             327,646      
  Stock and warrants issued to landlord     716,614             716,614  
  Issuance of preferred stock                 32,868,028  
  Repayment of subscription receivable                 5,000,000  
  Proceeds from capital leases                 495,851  
  Repayment of capital leases                 (1,031,395 )
  Repurchase company stock             (613,179 )   (613,179 )
  Proceeds from notes payable issued to investors                 3,550,000  
   
 
 
 
 
      Net cash provided by (used in) financing activities     43,377,825     74,676     17,539,814     151,293,734  
   
 
 
 
 
(Decrease) increase in cash and cash equivalents     25,165,758     (8,638,825 )   8,792,974     30,417,095  
Cash and cash equivalents, beginning of period     5,251,337     13,890,162     5,097,188      
   
 
 
 
 
Cash and cash equivalents, end of period   $ 30,417,095   $ 5,251,337   $ 13,890,162   $ 30,417,095  
   
 
 
 
 
Supplemental disclosure of cash flow information:                          
  Cash paid for interest   $   $   $   $ 488,126  
  Cash paid for taxes   $   $   $   $ 32,750  
  Assets acquired through capital lease   $   $   $   $ 535,445  

See notes to consolidated financial statements.

52



BEACON POWER CORPORATION AND SUBSIDIARY

(A Development Stage Company)

Notes to Consolidated Financial Statements

Note 1. Nature of Business and Operations

Nature of Business

        Beacon Power Corporation (collectively the "Company", "Beacon", "we", "our", or "us") (a development stage company) was incorporated on May 8, 1997 as a wholly owned subsidiary of SatCon Technology Corporation ("SatCon"). Since our inception, we have been primarily engaged in the development of flywheel devices for storing and transmitting kinetic energy. As discussed in Note 6, during the fourth quarter of 2000, we completed an initial public offering of our common stock and raised approximately $49.3 million, net of offering expenses. Since 2000, we have raised additional funds through the sale of our stock and warrants, as follows:

    On October 31, 2007, we sold 11,911,852 units of the Company at a purchase price of $2.10 per unit, for a total of approximately $23.8 million, net of expenses. Each unit consisted of one share of our common stock, par value $0.01 per share, and a warrant to purchase 0.95 shares of common stock at an exercise price of $2.97 per share, for a total of 11,316,260 warrants.

    In September 2007, we sold 5,102,041 units of the Company at a purchase price of $1.96 per unit for a total of approximately $9.2 million, net of expenses. Each unit consisted of one share of our common stock, par value $0.01 per share, and a warrant to purchase 1.2 shares of common stock at an exercise price of $1.99 per share, for a total of 6,122,449 warrants. In addition, 153,061 warrants were issued to the placement agents at the same price per share.

    On February 15, 2007, we issued approximately 11.8 million units for $0.90 per unit, each of which consists of one share of our common stock, par value $0.01 per share, and a warrant to purchase 0.5 shares of our common stock at an exercise price of $1.33 per share. We received net proceeds of approximately $9.8 million after deducting placement agency fees and estimated offering expenses.

    On November 8, 2005, we distributed 9,868,421 newly issued shares of our common stock at $1.52 per share. We also issued five-year warrants to purchase an additional 3,410,527 shares of common stock at an exercise price of $2.21 per share. This transaction resulted in net proceeds of approximately $14 million net of expenses and commissions in the amount of approximately $1 million.

    On May 24, 2005 and July 26, 2005 Perseus made investments of $1.5 million for a total of $3 million in exchange for 1,666,667 and 1,785,714 shares of common stock, respectively and the extension for two years of an existing warrant already owned by Perseus.

        Because we have not yet generated a significant amount of revenue from our principal operations, we are accounted for as a development stage company under Statement of Financial Accounting Standards No. 7.

        We have a single operating segment, developing alternative power sources. Our organizational structure has no divisions or subsidiaries dictated by product lines, geography or customer type. In 2007 we derived approximately 95% of our revenue from our research and development contracts; two of those contracts accounted for 84% of our total revenue. Although the loss of any single contract may have a material impact on our financial statements, it would not have a material impact on our business since we derive most of our working capital from equity offerings in order to develop our flywheel systems.

53


BEACON POWER CORPORATION AND SUBSIDIARY

(A Development Stage Company)

Notes to Consolidated Financial Statements (Continued)

Note 1. Nature of Business and Operations (Continued)

        We do not expect to become profitable or cash flow positive until at least 2010 and must raise additional equity to execute our business plan and continue as a going concern.

        Based on our current cash usage rates and additional expenditures expected in support of our business plan, and including the approximately $42.3 million equity we raised in 2007, net of expenses, we have enough cash to fund operations into approximately the fourth quarter of 2008. We will require substantial funds to complete research and development activities, market our products and services, deploy our systems, and increase our revenues. We anticipate that such funds will be obtained from external sources and intend to seek additional equity or debt to fund future operations. We estimate that we will need to raise an additional $20 million during 2008 through the issuance of equity securities in order to complete development of the Smart Energy Matrix™ flywheel system, and to build, operate and receive fees for frequency regulation services and yet have sufficient working capital to continue to execute our business plan. Our business plan includes manufacturing the flywheel systems and building the facilities for a multiple megawatt site in New York and a one to five megawatt facility at either NE ISO or PJM. Beyond 2008 we will continue to have capital needs that will require additional equity or debt, for example, to fund the complete build-out of the NY facility to 20 megawatts.

Operations

        We have experienced net losses since our inception and, as of December 31, 2007, had an accumulated deficit of approximately $163 million. We are focused on the commercialization of our Smart Energy Matrix™ flywheel system for frequency regulation and completion of our government research and development contracts. This commercialization will require substantial additional outlays of capital. We took significant actions over the three years ended 2005 to reduce our cash expenditures for product development, infrastructure and production readiness. However, our efforts in 2007 and 2006 were expanded as we ramped up efforts to develop our Smart Energy 25 flywheel, for which we have identified a sizeable market. Additionally, we completed our Sandia DOE contract to design and develop a 20 megawatt frequency regulation facility. We have also continued, at a reduced level, to assemble and sell our inverter product for solar energy applications. Although we are continuing to support the product, we do not believe that inverters will be a significant portion of our business going forward.

Note 2. Basis of Presentation and Summary of Significant Accounting Policies

Basis of Presentation

Going concern

        The accompanying consolidated financial statements have been prepared on a going concern basis, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. As shown in our consolidated financial statements, we had minimal revenues, and incurred significant losses of approximately $12,918,000, $12,163,000 and $9,312,000 and cash decreases from operations of approximately $11,282,000, $8,441,000 and $8,923,000 during the years ended December 31, 2007, 2006 and 2005, respectively. We have approximately $30,417,000 of cash and cash equivalents on hand at December 31, 2007, which is adequate to finance our business plan into

54


BEACON POWER CORPORATION AND SUBSIDIARY

(A Development Stage Company)

Notes to Consolidated Financial Statements (Continued)

Note 2. Basis of Presentation and Summary of Significant Accounting Policies (Continued)


approximately the fourth quarter of 2008. Since our cash requirements for operation and construction of frequency regulation facilities far exceeds the cash generated from operations, we may be unable to continue as a going concern. The consolidated financial statements do not include any adjustments relating to the recoverability and classification of liabilities that might be necessary should we be unable to continue as a going concern.

        We recognize that our continuation as a going concern is dependent upon our ability to generate sufficient cash flow to allow us to satisfy our obligations on a timely basis. The generation of sufficient cash flow is dependent, in the short term, on our ability to obtain adequate equity investments, and in the long term, on the successful development of our Smart Energy flywheel product and our ability to provide frequency regulation services to the electricity grid. We believe that the successful achievement of these initiatives should provide us with sufficient resources to meet our long-term cash requirements. In addition we are also considering a number of other strategic financing alternatives and have incurred substantial costs in these efforts; however, no assurance can be made with respect to the success of these efforts or the viability of our company.

Accounting Principles

        The accompanying consolidated financial statements have been prepared using accounting principles generally accepted in the United States of America.

Consolidation

        The accompanying consolidated financial statements include the accounts of Beacon Power Corporation and our subsidiary Beacon Power Securities Corporation. Our other subsidiary, Beacon Acquisition Co. was inactive in 2005 and was dissolved in 2006. All significant inter-company accounts and transactions have been eliminated in consolidation.

Recapitalization

        The accompanying financial statements reflect a recapitalization of the Company in 1997 when one shareholder exchanged shares of common stock for Class A preferred stock.

Recently Adopted Accounting Pronouncements and Recent Pronouncements

        Recently adopted accounting pronouncements and recent pronouncements are discussed in Part II, Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operation" of our Annual Report on Form 10-K, and are incorporated in these financial statements by reference.

Summary of Significant Accounting Policies

Use of Estimates

        The preparation of consolidated financial statements in accordance with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets

55


BEACON POWER CORPORATION AND SUBSIDIARY

(A Development Stage Company)

Notes to Consolidated Financial Statements (Continued)

Note 2. Basis of Presentation and Summary of Significant Accounting Policies (Continued)


and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

Cash and Cash Equivalents

        Cash and cash equivalents include demand deposits and highly liquid investments with maturities of three months or less when acquired. Cash equivalents are stated at cost, which approximates market value.

Accounts Receivable and Allowance for Doubtful Accounts

        We evaluate the collectability of our open receivables on an ongoing basis. Specific reserves for bad debt are recorded based on the age of receivables, and when we are notified of a customer's inability to satisfy its debt obligations, such as in the event of a bankruptcy filing. We provide an allowance for doubtful accounts equal to the estimated uncollectible amounts due from our customers. Our estimate is based on limited historical collection experience and a review of the current status of trade accounts receivable. Accounts receivable are presented in our balance sheets net of an allowance for doubtful accounts of $2,568 and $18,868 at December 31, 2007 and 2006, respectively.

        Two of our research and development contracts contain holdback provisions that allow our customers to withhold 10% from each invoice payment. As of December 31, 2007, approximately $68,000 of our accounts receivable balance represented holdbacks. These holdbacks are payable once the final reports have been received and approved. As the related contracts were recently completed, we believe these holdbacks will be collected during 2008, and therefore have not recorded any reserve against these amounts.

Inventories

        Inventories are stated at the lower of cost (first-in, first-out method) or market and consist of raw materials, work in process and finished goods held for resale. For years ended December 31, 2007, 2006 and 2005, reserves were recorded to fully offset the value of our inventory. These impairment charges were made due to the uncertainty of realizing any future value from the inventory due to the lack of substantial revenues to date from our inverter product line. Materials purchased to support our research and development efforts are expensed as incurred, in accordance with Statement of Financial Accounting Standards No. 2, "Accounting for Research and Development Costs." Materials purchased to produce Smart Energy 25 flywheels to be used in our frequency regulation facilities have been classified as Property and Equipment on our balance sheet. As of December 31, 2007, approximately $453,000 of production material was included in Property and Equipment.

Unbilled costs on contracts in process

        Contract costs that we incur in advance of billings to customers, such as material purchases, direct labor and overheads are reflected as a current asset on our balance sheet as "Unbilled costs on contracts in process."

56


BEACON POWER CORPORATION AND SUBSIDIARY

(A Development Stage Company)

Notes to Consolidated Financial Statements (Continued)

Note 2. Basis of Presentation and Summary of Significant Accounting Policies (Continued)

Prepaid Expenses and Other Current Assets

        Prepaid expenses at December 31, 2007 consist primarily of deferred lease payments of approximately $517,000, prepaid insurance premiums (primarily related to directors and officers liability insurance of approximately $368,000, and other prepaid expenses of approximately $590,000, which consist primarily of advances to vendors for long-lead orders and prepaid maintenance agreements. Prepaid expenses at December 31, 2006 consist of approximately $472,000 of prepaid insurance premiums (primarily related to directors and officers liability insurance), $148,000 related to advances to vendors for long-lead orders, $110,000 in deferred financing costs related to our equity raising activities, and other miscellaneous prepaid items such as patent retainers and software and other maintenance agreements.

Lease Obligation and Deferred Rent

        During July 2007, we signed a seven-year operating lease with escalating payments on a new facility in Tyngsboro, Massachusetts. As part of this lease agreement, we issued to the landlord 150,000 shares of our common stock and a warrant exercisable for 500,000 shares of our common stock in return for lower cash payments under the lease. (See Note 4: Commitments and Contingencies.) Additionally, the landlord has agreed to reimburse the Company for certain leasehold improvements. We have recorded rent expense on a straight line basis in accordance with SFAS No. 13, "Accounting for Leases." The deferred rent included in Prepaid expenses and other current assets as of December 31, 2007 is approximately $517,000.

Property and Equipment

        Property and equipment, including leasehold improvements, are stated at cost and depreciated using the straight-line method over the estimated useful lives of the assets. The cost of the item is defined as the purchase price of the item, as well as all of the costs necessary to bring it to the condition and location necessary for its intended use. Repair and maintenance costs are expensed as incurred. Capital assets are classified as "Construction in Progress" (CIP) when initially acquired, and reclassified to the appropriate asset account after being placed into service. Depreciation expense is not recorded on assets not yet placed into service. Materials purchased to build flywheels for use in our frequency regulation facilities is classified as CIP, along with related labor and overhead costs. No overhead is generally applied for other internally-constructed projects not directly related to our core business (e.g., leasehold improvements.)

Loss on Contract Commitments

        Our contracts have been primarily for the development of demonstration units of new products and the design of a frequency regulation plant. As such, the work has supported our core research and development efforts. We establish reserves for anticipated losses on contract commitments if, based on our cost estimates to complete the commitment, we determine that the cost to complete the contract will exceed the total expected contract revenue. Most of our contracts have been granted on a cost-share basis, for which the expected cost-share is recorded as a contract loss. Additionally, each quarter we perform an evaluation of expected costs to complete our in-progress contracts and adjust the contract loss reserve accordingly. We recorded charges of approximately $1,385,000 and $1,534,000

57


BEACON POWER CORPORATION AND SUBSIDIARY

(A Development Stage Company)

Notes to Consolidated Financial Statements (Continued)

Note 2. Basis of Presentation and Summary of Significant Accounting Policies (Continued)


during 2006 and 2005, respectively, for anticipated losses on our research and development contracts. Approximately $240,000 of this charge in 2006 relates to the cost share portion of a contract awarded to us during the third quarter of 2006 from the U.S. Department of Energy (DOE) (to be administered by Sandia National Laboratories) to design a 20-megawatt Smart Energy Matrix™ frequency regulation power plant. The remainder of the 2006 charge relates to a revision of our labor and overhead rates and other estimated costs to complete our remaining contracts based upon current forecasts. During 2007, we completed all but one contract. Our actual costs to complete these contracts were less than previously estimated; accordingly we reduced our contract loss reserve by approximately $578,000.

Impairment of Long-Lived Assets

        In accordance with Statement of Financial Accounting Standards No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets," long-lived assets to be held and used are reviewed to determine whether any events or changes in circumstances indicate that the carrying value of the asset may not be recoverable. The conditions considered include whether or not the asset is in service, has become obsolete, or whether external market circumstances indicate that the carrying amount may not be recoverable. We recognize a loss for the difference between the estimated fair value of the asset and the carrying amount. The fair value of the asset is measured using either available market prices or estimated discounted cash flows.

Other assets and deferred financing costs

        We will defer our direct costs incurred to raise capital or to acquire an entity in a business combination. Direct costs include only "out-of-pocket" or incremental costs directly related to the effort, such as a finder's fee and fees paid to outside consultants for accounting, legal, or engineering investigations or for appraisals. These costs will be capitalized if the efforts are successful, or expensed when unsuccessful. Indirect costs are expensed as incurred.

Advance billings on contracts

        We may receive performance-based payments and progress payments from customers which may exceed costs incurred on certain contracts, including contracts with agencies of the U.S. Government. Such advances are classified as current liabilities.

Restructuring and asset impairment charges

        We periodically evaluate all of our property and equipment as required by Statement of Financial Accounting Standards No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets." In 2002, we incurred a restructuring and impairment charge of $6.5 million, of which $4.3 million represents impaired capital equipment and leasehold improvements, $.3 million relates to severance costs and $1.9 million relates to a reserve against future lease payments and related facility costs. The reserve against future lease payments is classified as "Restructuring reserve" in the current liabilities section of the balance sheet.

58


BEACON POWER CORPORATION AND SUBSIDIARY

(A Development Stage Company)

Notes to Consolidated Financial Statements (Continued)

Note 2. Basis of Presentation and Summary of Significant Accounting Policies (Continued)

        The restructuring reserves are as follows:

 
  Year ended December 31,
 
 
  2007
  2006
 
Beginning balance   $ 347,408   $ 713,469  
Charges for the period          
Reductions     (347,408 )   (366,061 )
   
 
 
Ending balance   $   $ 347,408  
   
 
 

Revenue Recognition

        Although we have shipped products and recorded contract revenues, our operations have not yet reached a level that would qualify us to emerge from the development stage. Therefore we continue to be accounted for as a development stage company under Statement of Financial Accounting Standards No. 7, "Accounting and Reporting by Development Stage Enterprises."

Product Sales

        We recognize revenues on product sales in accordance with accounting principles generally accepted in the United States of America. Generally, revenue on inverter sales is recognized on transfer of title, typically when products are shipped and all related costs are estimable. For sales to distributors, we make an adjustment to defer revenue until the products are subsequently sold by distributors to their customers. We have determined that this treatment will ensure that the recognition of revenue cannot be impacted by any disputes between us and our distributors on product or possible issues resulting from technology risk as new products are introduced that may have enhanced functionality compared to product in distributor inventory.

Government Contract Revenue Recognized on the Percentage-of-Completion Method

        We recognize contract revenues using the percentage-of-completion method. Pursuant to American Institute of Certified Public Accountants' Statement of Position No. 81-1, "Accounting for Performance of Construction-Type and Certain Production-Type Contracts" (SOP 81-1), the efforts-expended method, which is based on a measure of the work performed, is an acceptable methodology for determining the amount of revenue to recognize in a given period. We use labor hours as the basis for the percentage of completion calculation, which is measured principally by the percentage of labor hours incurred to date for each contract to the estimated total labor hours for each contract at completion.

        Each quarter we perform an estimate-to-complete analysis, and any changes to our original estimates are recognized in the period in which they are determined. Changes in project performance and conditions, estimated profitability, and final contract settlements may result in future revisions to construction contract costs and revenue. During 2006 we recorded contract losses of approximately

59


BEACON POWER CORPORATION AND SUBSIDIARY

(A Development Stage Company)

Notes to Consolidated Financial Statements (Continued)

Note 2. Basis of Presentation and Summary of Significant Accounting Policies (Continued)


$1,385,000. In 2007, we reversed approximately $578,000 of these losses, as we completed the contracts at a lower cost than previously estimated. Our contract loss reserves are as follows:

 
  Year ended December 31,
 
 
  2007
  2006
 
Beginning balance   $ 821,032   $ 548,614  
Charges (credits) for the period     (577,789 )   1,384,978  
Reductions     (175,824 )   (1,112,560 )
   
 
 
Ending balance   $ 67,419   $ 821,032  
   
 
 

Cost of Goods Sold

        We cost our products at the lower of cost or market. Costs in excess of this measurement are expensed in the period in which they are incurred. We provide a five-year limited product warranty for our Smart Power M-series product line and accrue for estimated future warranty costs in the period in which the revenue is recognized. In 2004, we established a reserve for our Smart Power M-series inventory as a result of lower than anticipated sales volumes. During 2007, 2006 and 2005 we continue to have very limited sales of our inverter products. The costs related to these sales are not fully reflected in the cost of goods sold as a result of the inventory having been reserved in a prior year. Therefore, our cost of goods sold does not fully reflect the costs associated with these revenues. For government contracts, cost of sales is calculated on the same percentage of contract costs (up to the total contract revenue amount) as is used to calculate revenue. Costs in excess of the total contract revenue amount are charged to contract loss.

Stock-Based Compensation

        During the first quarter of 2006, we adopted the provisions of, and accounted for, stock-based compensation in accordance with the Financial Accounting Standards Board's Statement of Financial Accounting Standards No. 123R ("SFAS 123R"), "Share-Based Payment." Under the fair value recognition provisions of SFAS 123R, stock-based compensation cost is measured at the grant date based on the fair value of the award and is recognized as an expense as it is earned over the requisite service period, which is the vesting period. To implement this standard, we elected the modified-prospective transition method, under which prior periods are not revised for comparative purposes. The fair value of the options on their grant date was measured using the Black-Scholes option-pricing model, which we believe yields a reasonable estimate of the fair value of the grants made. The valuation provisions of SFAS 123R apply to new grants and to grants that were outstanding as of the effective date and are subsequently modified. Estimated compensation expense for grants that were outstanding as of the effective date will be recognized over the remaining vesting period using the compensation cost estimated for the SFAS 123R pro forma disclosures.

        The adoption of SFAS 123R had a material impact on our consolidated financial position and results of operations. See Note 8 for further information regarding our stock-based compensation assumptions and expenses, including pro forma disclosures for prior periods as if we had recorded stock-based compensation expense during such periods.

60


BEACON POWER CORPORATION AND SUBSIDIARY

(A Development Stage Company)

Notes to Consolidated Financial Statements (Continued)

Note 2. Basis of Presentation and Summary of Significant Accounting Policies (Continued)

        We granted Restricted Stock Units to employees for services performed in 2005, 2004 and 2003 that vested quarterly during the subsequent year. In addition, our officers were granted restricted stock units as part of their compensation agreements in 2006 and 2007. Our Restricted Stock Unit Deferred Compensation Plan is described in more detail in Note 8.

Income Taxes

        Deferred income tax assets and liabilities are determined based on the differences between the financial reporting and tax bases of assets and liabilities and tax loss and credit carry forwards using the currently enacted tax rates and laws. A valuation allowance has been provided because realization of deferred tax assets is unlikely in the near future (see Note 9).

Advertising

        Advertising expense was approximately $1,000, $10,000 and $14,000 in 2007, 2006 and 2005 respectively, and is expensed as incurred.

Research and Development

        Research and development costs are expensed as incurred, except costs that relate to our government contracts. Those expenses are capitalized as "Unbilled costs on contracts in progress" and charged to Cost of Goods Sold once the revenue is recognized under the percentage of completion method, or charged against the Contract Loss Reserve as incurred if the costs are not recoverable under the terms of the contract agreement or if the costs exceed the total revenue expected for the contract.

Casualty loss

        On December 28, 2006, a malfunction occurred during the testing of a Smart Energy 25 flywheel which resulted in the loss of the flywheel and other inventory (which had previously been expensed), as well as minor damage to the building improvements and other equipment. A casualty loss of approximately $69,000 was recorded in 2006 for the estimated cost of repairs to the building improvements, repair fixed assets, replace damaged supplier equipment and perform necessary clean up. Additional costs to complete the building clean up, assess the cause of the failure, repair damaged equipment and replace previously-expensed inventory and materials that were damaged or destroyed were approximately $345,000. During 2007, we recovered approximately $336,000 of these costs from insurance.

Fair Value of Financial Instruments

        The carrying amount of cash and cash equivalents, accounts receivable, inventory, accounts payable, accrued expenses, and other current assets and liabilities approximate their fair values.

61


BEACON POWER CORPORATION AND SUBSIDIARY

(A Development Stage Company)

Notes to Consolidated Financial Statements (Continued)

Note 2. Basis of Presentation and Summary of Significant Accounting Policies (Continued)

Concentration of Credit Risk

        Financial instruments that potentially subject us to significant concentration of credit risk consist primarily of cash and cash equivalents. We keep our cash investments with high-credit-quality financial institutions or Treasury funds. At December 31, 2007 substantially all of our cash and cash equivalents were held in interest bearing accounts at financial institutions earning interest at varying rates from 3.30% to 7.65%. At December 31, 2007 and 2006, we had cash balances at a financial institution in excess of federally insured limits. However, we do not believe that it is subject to unusual credit risk beyond the normal credit risk associated with commercial banking relationships.

Comprehensive Loss

        Comprehensive loss is the same as net loss for all periods presented.

Loss per Share—Basic and Diluted

        Basic loss per share has been computed using the weighted-average number of shares of common stock outstanding during each period. Warrants, options and other securities exercisable for common shares are used in the calculation of fully-diluted EPS only if their conversion to common shares would decrease income or increase loss per share from continuing operations. Since the years ended December 31, 2007, 2006 and 2005 reflect losses, including the potential conversion of warrants and options in the diluted EPS calculation would decrease loss per share. Thus, they are considered anti-dilutive and are not included in the calculation of earnings per share.

Note 3. Property and Equipment

        Property and equipment consisted of the following:

 
   
  As of December 31,
 
 
  Estimated
Useful Lives

 
 
  2007
  2006
 
Construction in Progress   Varied   $ 5,782,127   $ 70,361  
Machinery and equipment   5—10 years     1,137,946     744,514  
Service vehicles   5 years     16,763     16,763  
Furniture and fixtures   7 years     603,382     255,940  
Office equipment   3 years     828,918     1,486,951  
Leasehold improvements   Lease term         533,352  
Equipment under capital lease obligations   Lease term     700,516     918,285  
       
 
 
  Total       $ 9,069,652   $ 4,026,166  
Less accumulated depreciation and amortization         (2,065,631 )   (3,610,760 )
       
 
 
  Property and equipment, net       $ 7,004,021   $ 415,406  
       
 
 

        As of December 31, 2007, "Construction in Progress" (CIP) included approximately $5,101,000 in leasehold improvements related to the build-out of the Tyngsboro facility (most of which was placed into service during January, 2008), approximately $453,000 in materials purchased to build production flywheels to be used in our frequency regulation facility, and approximately $17,000 for an option to

62


BEACON POWER CORPORATION AND SUBSIDIARY

(A Development Stage Company)

Notes to Consolidated Financial Statements (Continued)

Note 3. Property and Equipment (Continued)


purchase land in New York to be used as a site for our frequency regulation facility. The remaining costs in CIP, approximately $211,000 relate to various machinery, equipment, tooling, software and computer equipment which were not in service as of December 31, 2007.

Note 4. Commitments and Contingencies

        The following table summarizes our cash commitments at December 31, 2007:

 
  Description of Commitment
 
  Operating leases
  Purchase Obligations
  Total
Year ending:                  
  December 31, 2007   $   $ 4,971,921   $ 4,971,921
  December 31, 2008     503,687           503,687
  December 31, 2009     701,687           701,687
  December 31, 2010     727,437           727,437
  December 31, 2011     753,188           753,188
  December 31, 2012     778,937           778,937
  Thereafter     1,422,689           1,422,689
   
 
 
  Total Commitments   $ 4,887,625   $ 4,971,921   $ 9,859,546
   
 
 

        At December 31, 2007, we had firm purchase commitments with our suppliers to acquire components for these commercial flywheel units, complete the build-out of the Tyngsboro facility, and to satisfy contractual obligations for our research and development programs in the amount of approximately $5.0 million.

        In July 2007, we signed a seven-year lease on a new corporate headquarters that significantly expands our manufacturing capacity and provides sufficient space to continue our research and development activities. Our new facility is located at 65 Middlesex Road, Tyngsboro, MA. The 103,000 square foot facility, which has manufacturing capacity for the production of more than 1,000 flywheels per year, has been renovated and built out to our specifications, and we relocated all operations to our new corporate headquarters in January 2008. The lease on our previous facility in Wilmington, MA expired at the end of November 2007.

        We have provided the Wilmington and Tyngsboro lessors with irrevocable letters of credit securing our performance under these leases with a balance at December 31, 2007 of $374,346, which are reduced periodically during the lease terms. These letters of credit are secured by a cash deposit, which is included in restricted cash in the accompanying consolidated balance sheets. In addition, we are responsible for real estate taxes and all operating expenses of the Tyngsboro facility.

        Additional capital expenditures will be required in the future to optimize the plant for maximum capacity. The amount and timing of these expenditures are dependent on requirements of equipment needed to meet production schedules as well as having sufficient funding.

63


BEACON POWER CORPORATION AND SUBSIDIARY

(A Development Stage Company)

Notes to Consolidated Financial Statements (Continued)

Note 4. Commitments and Contingencies (Continued)

        Rent expense was $732,534, $237,695 and $231,188 during 2007, 2006 and 2005, respectively net of restructuring reserves applied of $253,491 $337,988 and $321,103, respectively. Rent expense in 2007 included rent on both the Tyngsboro and Wilmington facilities between July and November.

        By the end of 2007, we had substantially completed all critical performance tests on the Smart Energy 25 flywheel, and as a result we have placed orders for materials required to build our first 10 commercial flywheel units.

Legal Proceedings

        We may be subject to various legal proceedings, many involving routine litigation incidental to our business. The outcome of any legal proceeding is not within our complete control, is often difficult to predict and may be resolved over very long periods of time. Estimating probable losses associated with any legal proceedings or other loss contingencies are very complex and require the analysis of many factors including assumptions about potential actions by third parties. Loss contingencies are recorded as liabilities in the consolidated financial statements when it is both, (i) probable or known that a liability has been incurred and (ii) the amount of the loss is reasonably estimable. If the reasonable estimate of the loss is a range and no amount within the range is a better estimate, the minimum amount of the range is recorded as a liability. If a loss contingency is not probable or not reasonably estimable, a liability is not recorded in the consolidated financial statements.

        On October 9, 2007, Arete Power, Inc. filed a complaint against us claiming damages from alleged willful infringement of U.S. Patent No. 6,710,489, entitled "Axially Free Flywheel System." On November 30, 2007, we filed an Answer denying infringement and a Counterclaim seeking a declaratory judgment that the '489 patent is invalid. At the same time, we filed a motion to transfer the lawsuit from the Northern District of California to the District of Massachusetts. On February 22, 2008, the Court granted our motion to transfer the lawsuit to the District of Massachusetts. We believe that this lawsuit is without merit and we plan to vigorously defend the Company against the lawsuit.

Note 5. Preferred Stock

        As a result of the initial public offering of our common stock and the conversion of all outstanding shares of all classes of the preferred stock, we amended our charter and cancelled all our classes of preferred stock. We then added a new class of preferred stock that can be issued in the future by filing a Certificate of Designations with the specific terms as set by our Board of Directors. At December 31, 2007 and 2006, there are 10 million shares of $.01 par value preferred stock authorized with none outstanding.

Note 6. Common Stock

        On October 31, 2007, we sold 11,911,852 units of the Company at a purchase price of $2.10 per unit, for a total of approximately $23.8 million, net of expenses. Each unit consisted of one share of our common stock, par value $0.01 per share, and a warrant to purchase 0.95 shares of common stock at an exercise price of $2.97 per share, for a total of 11,316,260 warrants. The units were issued pursuant to a prospectus supplement filed with the Securities and Exchange Commission in connection

64


BEACON POWER CORPORATION AND SUBSIDIARY

(A Development Stage Company)

Notes to Consolidated Financial Statements (Continued)

Note 6. Common Stock (Continued)


with our registration statement on Form S-3 for $50 million filed on August 6, 2007, which we amended on August 14, 2007 and became effective on August 15, 2007.